(b) Explain whether Sunway Real Estate Investment Trust berhad should involve hedging or not hedging. Why or why not? Sunway Real Estate Investment Trust (Sunway REIT) berhad should involve hedging because it exposes to the foreign currency exposure and exchange rate fluctuations. Since successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes and so on and so forth, Sunway Real Estate Investment Trust should involve in hedging to reduce these types of risks. Indeed, Sunway Real Estate Investment Trust does involve hedging to reduce exchange rate risk by having a three-year fixed rate US dollar 100 million term loan which has been fully hedged via a cross currency swap (Sunway REIT annual report, 2013). Besides, Sunway Real Estate Investment Trust has also used cash flow hedges to mitigate the risk of variability of future cash flows attributable to foreign currency and interest rate fluctuations over the hedging period on the foreign currency borrowings (Sunway REIT annual report, 2013). Besides reducing the exchange rate risk, hedging can be used for enhancing a companyâ€™s value. In the overall managerial strategy, reducing corporate risk is an essential component. Several market imperfections make risk management an essential goal for companies. These market imperfections lead to the reduction of the value of companies by making volatility an expensive proposition. The imperfections, in turn, contribute to other market deficiencies such as expensive financial distress costs (Myers, 1977 and Smith & Stulz, 1985); external financing (Froot, Scharfstein & Stein, 1993); agency costs; and costs pertaining to managerial risk aversion. These imperfections have a negative effect on a companyâ€™s value. By helping reduce costs resulting from such imperfections, hedging enhances a companyâ€™s value (Ghosh, 2013). In addition, hedging helps to reduce distress costs. The ability to raise capital is extremely important in the event of a perceived or real distress faced by a company. Every business faces the possibility of distress under adverse circumstances (Damodaran, 2008). Even perceived circumstances of distress can be costly for companies â€“ often in the range of 20% to 40% of the companyâ€™s value (Shapiro & Titman, 1985). In the extreme event, distress can lead to bankruptcy. Hence, it is prudent for companies to protect themselves from the risk of distress events by hedging against them. Damodaran (2008) estimates that the payoff from lower distress costs can show up in the companyâ€™s value in one of the two ways. In a conventional discounted cash flow valuation, the effect is likely to manifest itself as a lower cost of capital which is through a lower cost of debt and a higher value. In the adjusted present value approach, the expected bankruptcy costs will be reduced as a result of hedging. To the extent that the increase in value from reducing distress costs exceeds the cost of hedging, the value of the company will increase. When likely distress costs are large, benefits from hedging by the means of savings on distress costs are likely to be significant. Kale and Noe (1990) have noted that hedging can increase the value of companies which are highly levered. Finally, by reducing the cost of financial distress, hedging can also enhance credit quality and reduce the cost of debt financing (Chidambaran, Fernando & Spindt, 2001). Moreover, hedging ensures continuity of cash flows. Price volatility has a negative impact on the revenue streams and can disrupt cash flows. Hedging prevents the companies from price volatility and ensures uninterrupted and stable revenue streams. Companies, through hedging, can choose what proportion of production to hedge and how far into the future the hedged position is to be established and maintained which can bring about certainty in their production process, and ensure continuity of cash flows. This is especially true for small companies with high costs, which are probably unwilling to accept the reduced risk for additional, risk-mitigated profits. Thus, the certainty in production planning at guaranteed minimum prices by using commodity futures to hedge, protect both a companyâ€™s future and that of its employees (Ghosh, 2013). Furthermore, hedging can be used to lower tax liabilities. A more visible strategic reason for hedging is the immediate impact it can have on tax liabilities of companies. Under a progressive taxation regime, losses of companies can be carried over for a finite number of years only. Over a medium to long run, therefore, volatile earnings induce higher taxation than stable earnings. Stulz (1996) empirically proved this argument to hold good in any regime marked by convexity of the tax code, for example, increasing marginal tax rates, limits on the use of tax-loss carry forward and minimum tax rates. A second tax saving from hedging arises from the increasing debt capacity of companies, which in turn increases the interest tax deductions. Graham & Rogers (2002) have performed empirical testing for 442 companies and found that the statistical benefit from increased debt capacity was 1.1% of the value of these companies. They also found that companies hedge to reduce the expected cost of financial distress. Thus, higher tax benefit is a tangible outcome from hedging, which, however, should not overshadow the clear benefits of risk management bestowed by this practice (Ghosh, 2013). On top of that, hedging serves as a strategic resource. One of the biggest strategic use of hedging as a corporate practice is, probably, the force multiplier it acts as in the resource pool of companies. By locking in prices of inputs and outputs, hedging releases valuable resources which can be better deployed for the companyâ€™s growth. Similarly, the ability of the company to stabilize its costs and hence control its pricing policy is itself a valuable resource of the company. Following the theory of Resource Based View (RBV) of the company (Rumelt, 1984 and Hamel & Prahlad, 1994), this control over price stabilization is an inimitable resource. It has the potential to be a source of differentiation to the company, bestowing competitive advantage over its competitors. In this way, companies can turn price volatility in raw materials and finished products into a key differentiator, giving them more opportunity to reduce costs, achieve higher average profitability and expand market share. Last but not least, hedging can also be served a tool for corporate governance. An important strategic function fulfilled through hedging lies in its role in corporate governance of companies. In a typical example of â€˜agency riskâ€™, it is possible to argue that managers of companies act in their self-interest, rather than in the interests of shareholders. While investors want the management to take risks in the interest of the company and the financial results of a company provide signals to boards and investors concerning the skills of its management, it is rather difficult for shareholders and the Board to differentiate between risk-taking behaviour of managers that is desirable from the risk-taking activity that leads to volatility in earnings, caused by management incompetence. This difficulty in identifying the value-creating from value-destroying risks in companies often leads to Boards seeking management action to eschew all types of risks. Often, managerial incentive structure including performance measure is linked to the extent of risk mitigated by managers. Besides, there may not be adequate human resources in the company to identify, manage and remove the undesirable risks from those that are desirable. As a result of these two factors, managers may reject investments that add value to the company in the long run, simply because the company-specific risk exposure, encompassing both the undesirable and desirable risks, seems to build up. Hedging allows a way out of this dichotomy. By driving a wedge between risks that are external to the company from those that are internal and then establishing a well thought- out Risk Management Policy that seeks to transfer avoidable risks out of the company in a transparent manner, hedging can delineate between the two types of risks. By transferring the external and avoidable risks through a large external market such as the commodity derivatives market, hedging also enables investors to segregate between legitimate and reckless risk-taking management behavior. Thus, hedging can promote sound corporate governance practices by providing a solution to investors to assess managerial performance (Ghosh, 2013). In conclusion, hedging helps in reducing exchange rate risk, enhancing a companyâ€™s value, reducing distress costs, enhancing credit quality, reducing cost of debt financing, ensuring continuity of cash flows, lowering tax liabilities and serving as a strategic resource as well as a tool for corporate governance. Since hedging brings so many benefits and advantages to the company, Sunway Real Estate Investment Trust (REIT) berhad should involve hedging as a strategy in order to sustain profitability, competitiveness and growth in the industry.
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