Harvard Case - Saginaw Parts Co. and the General Motors Corp. Credit Default Swap
"Saginaw Parts Co. and the General Motors Corp. Credit Default Swap" Harvard business case study is written by William E. Fruhan. It deals with the challenges in the field of Finance. The case study is 2 page(s) long and it was first published on : Feb 12, 2010
At Fern Fort University, we recommend that Saginaw Parts Co. carefully assess the risks and potential rewards of entering into a credit default swap with General Motors Corp. While the swap offers potential financial benefits, it also introduces significant risks that require thorough analysis and mitigation strategies.
2. Background
The case study revolves around Saginaw Parts Co., a supplier of automotive parts to General Motors Corp. (GM). Saginaw faces a significant financial risk due to GM's precarious financial position and the potential for a credit default. This risk directly impacts Saginaw's revenue stream and overall financial stability. The case study presents the opportunity for Saginaw to enter into a credit default swap (CDS) with GM, which would provide financial protection against a potential GM default.
The main protagonists of the case study are:
- Saginaw Parts Co.: A supplier heavily reliant on GM for revenue, facing financial risk due to GM's creditworthiness.
- General Motors Corp.: A large automaker struggling financially, potentially posing a credit risk to its suppliers.
- The Credit Default Swap (CDS): A financial instrument offering protection against a potential default by a borrower.
3. Analysis of the Case Study
To analyze the case, we will utilize a framework incorporating financial analysis, risk management, and strategic considerations:
Financial Analysis:
- Financial Statements: Analyze GM's financial statements (balance sheet, income statement, cash flow statement) to assess its financial health, debt levels, profitability, and cash flow generation.
- Ratio Analysis: Calculate key financial ratios such as liquidity ratios (current ratio, quick ratio), profitability ratios (gross profit margin, net profit margin), and leverage ratios (debt-to-equity ratio, debt-to-asset ratio) to gain a deeper understanding of GM's financial performance.
- Valuation Methods: Employ valuation methods like discounted cash flow (DCF) analysis to determine the intrinsic value of GM and assess whether its current market price reflects its true worth.
- Cost of Capital: Calculate GM's cost of capital (WACC) to understand the cost of financing its operations and its ability to service its debt obligations.
Risk Management:
- Credit Risk Assessment: Conduct a thorough credit risk assessment of GM, considering its financial performance, industry outlook, and potential for default.
- Hedging Strategies: Evaluate the effectiveness of the CDS as a hedging instrument against GM's credit risk, considering the cost of the CDS and its potential to mitigate financial losses.
- Counterparty Risk: Assess the creditworthiness of the counterparty offering the CDS, considering their financial stability and potential for default.
Strategic Considerations:
- Business Relationships: Analyze the impact of the CDS on Saginaw's relationship with GM. Consider potential implications for future business negotiations and collaboration.
- Long-Term Strategy: Evaluate the long-term implications of the CDS on Saginaw's financial strategy, considering its overall risk appetite and growth objectives.
- Competitive Landscape: Assess the impact of the CDS on Saginaw's competitive position within the automotive supply chain, considering the potential for other suppliers to utilize similar hedging instruments.
4. Recommendations
Based on the analysis, we recommend the following:
- Conduct a comprehensive financial analysis of GM: This analysis should include a thorough review of its financial statements, ratio analysis, and valuation methods.
- Perform a detailed credit risk assessment of GM: This assessment should consider its financial performance, industry outlook, and potential for default.
- Evaluate the effectiveness of the CDS as a hedging instrument: Consider the cost of the CDS, its potential to mitigate financial losses, and the creditworthiness of the counterparty offering the CDS.
- Assess the impact of the CDS on Saginaw's business relationship with GM: Consider potential implications for future business negotiations and collaboration.
- Develop a comprehensive risk management strategy: This strategy should include identifying, assessing, and mitigating risks associated with the CDS and GM's creditworthiness.
- Consider alternative hedging strategies: Explore other potential hedging instruments, such as insurance or other financial derivatives, to diversify risk and potentially reduce costs.
- Monitor GM's financial performance and credit rating closely: Continuously track GM's financial performance and its credit rating to assess the effectiveness of the CDS and adjust hedging strategies as needed.
5. Basis of Recommendations
The basis of our recommendations considers the following factors:
- Core competencies and consistency with mission: The recommendations align with Saginaw's core competency as an automotive parts supplier and its mission to remain financially stable and profitable.
- External customers and internal clients: The recommendations prioritize the interests of Saginaw's external customers (GM) and internal clients (employees, shareholders) by mitigating financial risks and ensuring long-term sustainability.
- Competitors: The recommendations consider the competitive landscape and the potential for other suppliers to utilize similar hedging instruments.
- Attractiveness ' quantitative measures: The recommendations are supported by quantitative measures such as financial ratios, valuation methods, and risk assessment analysis.
6. Conclusion
Saginaw Parts Co. faces a significant financial risk due to GM's creditworthiness. Entering into a credit default swap with GM offers potential financial protection but also introduces significant risks. A thorough analysis of the risks and rewards, coupled with a comprehensive risk management strategy, is crucial for Saginaw to make an informed decision.
7. Discussion
Alternative options to the CDS include:
- Diversifying customer base: Reducing reliance on GM by expanding to other automotive manufacturers.
- Improving operational efficiency: Reducing costs and improving profitability to increase financial resilience.
- Negotiating favorable payment terms with GM: Seeking extended payment terms or other concessions to mitigate short-term cash flow risks.
Key assumptions include:
- GM's financial performance: The effectiveness of the CDS hinges on the accuracy of the assessment of GM's financial performance and its potential for default.
- Counterparty risk: The creditworthiness of the counterparty offering the CDS is crucial to ensure the effectiveness of the hedging instrument.
- Market conditions: The effectiveness of the CDS can be influenced by broader market conditions, such as interest rates and economic growth.
8. Next Steps
The following steps should be taken to implement the recommendations:
- Timeline:
- Month 1: Conduct financial analysis of GM and credit risk assessment.
- Month 2: Evaluate the CDS and alternative hedging strategies.
- Month 3: Develop a comprehensive risk management strategy.
- Month 4: Negotiate terms with the counterparty offering the CDS.
- Month 5: Implement the chosen hedging strategy.
- Key milestones:
- Completion of financial analysis and credit risk assessment.
- Selection of the most effective hedging strategy.
- Negotiation and execution of the CDS contract.
- Ongoing monitoring of GM's financial performance and credit rating.
By taking these steps, Saginaw Parts Co. can effectively manage its financial risks and ensure its long-term sustainability in the face of potential challenges posed by GM's creditworthiness.
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Case Description
This two-page case demonstrates how to unbundle the cost of credit extensions from product prices by observing the price of a credit default swap. It also explores how credit default swaps work, and how trade creditors are treated under U.S. bankruptcy law. Finally it provides a quick overview of the bankruptcy of General Motors Corp.
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