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Annual Report 1996


3. Financial Instruments

Foreign Exchange Risk Management:
The Company generates a substantial portion of its revenues in international markets, which subjects its operations to the exposure of foreign currency fluctuations. The impact of currency fluctuations can be positive or negative in any given period. The Company's ability to counteract foreign currency exchange movement is primarily dependent on pricing.

To minimize the adverse impact of foreign currency fluctuations on its foreign currency-denominated net assets, the Company may engage in foreign currency-denominated borrowings (see Note 6). The Company determines the aggregate amount of such borrowings based on its forecast of the Company's net asset position and the relative strength of the U.S. dollar as compared to foreign currencies. These borrowings create foreign currency-denominated liabilities that hedge the Company's foreign currency-denominated net assets. Upon receipt of the borrowed foreign currency-denominated funds, the Company converts those funds to U.S. dollars at the spot exchange rate. Exchange gains and losses on the foreign currency-denominated borrowings are recognized in earnings as incurred. At December 31, 1996 and 1995, the amount of the Company's outstanding short-term foreign currency-denominated borrowings were $122.9 million and $140.4 million, respectively.

From time to time, the Company may use over-the-counter foreign exchange swaps to reduce the interest expense incurred on its overseas borrowings. When a foreign exchange swap is used, the currency received by the Company in the spot market component of the foreign exchange swap is used to close out borrowings in a similar currency and, simultaneously, the original borrowing position is reinstituted through a forward contract (not exceeding six months). The net interest value of the foreign exchange swap contract is amortized to earnings over the life of the contract. Exchange gains or losses on the foreign currency component of the forward contract are recognized in earnings as incurred in each accounting period. The Company does not enter into foreign exchange swaps for trading purposes. There were no foreign exchange swap contracts outstanding at December 31, 1996. The aggregate notional value of the Company's short-term foreign exchange swap contracts was $16.2 million at December 31, 1995.

When the Company may not have sufficient flexibility to increase prices in local currency to reflect any appreciation of the U.S. dollar, the Company may, from time to time, also purchase U.S. dollar call options. The term of these call options typically does not exceed one year. The Company's purchase of call options allows it to protect a portion of its expected foreign currency-denominated revenues from adverse foreign currency exchange movement. The Company does not buy call options which can be exercised prior to the expiration date, nor does it write options or purchase call options for trading purposes. The Company defers premiums and any gains for its call options activity until the option exercise date. No option contracts were outstanding at December 31, 1996 and 1995.

The Company maintains a Monetary Control Center (the MCC), which operates under written policies and procedures defining day-to-day operating guidelines, including exposure limits, to contract for the foreign currency-denominated borrowings, foreign exchange swaps and call options described above. The MCC is subject to random independent audits and reports to a supervisory committee comprised of members of the Company's management. The MCC publishes monthly reports to the Company's management detailing the foreign currency activities it has engaged in for the prior month.

Interest Rate Risk:
The Company is exposed to interest rate risk. To minimize the risks and costs associated with the refinancing of the 7 1/4% Notes due January 15, 1997, the Company purchased interest rate agreements with a notional value of $125.0 million from two financial institutions. The agreements protected the Company from interest rates above the contracted rate. If interest rates fell below this rate, the Company would have had to pay the financial institutions the differential interest. In early January 1997, the Company settled these interest rate contracts and received net proceeds of $.8 million from the financial institutions.

Fair Value:
The carrying amounts of cash, cash equivalents, short-term investments, trade receivables, short-term debt and trade payables approximate fair value because of the short maturity of these financial instruments. Other assets include investments in nonmarketable private companies which are carried at the lower of cost or net realizable value. The estimated aggregate fair value of these investments approximated the carrying amount as of December 31, 1996. As of December 31, 1996, the carrying amount and fair value of the Company's long-term debt was $527.6 million and $537.0 million, respectively. As of December 31, 1995, the carrying amount and fair value of the Company's long-term debt was $566.4 million and $647.0 million, respectively.

The estimated fair value of the Company's call options and foreign exchange swaps, if any, generally reflects the estimated amounts the Company would receive or pay to terminate the contracts at the reporting dates, thereby taking into account the current unrealized gains or losses on open contracts. There were no foreign exchange swap contracts outstanding at December 31, 1996 and there were no option contracts outstanding at December 31, 1996 and 1995. The aggregate notional value of the Company's short-term foreign exchange swap contracts was $16.2 milion at December 31, 1995. These contracts did not have a net carrying amount nor a fair value at December 31, 1995.

Dealer quotes are available for the Company's call options and foreign exchange swaps. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities.

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect estimates.

Concentration of Credit Risk:
The Company places its temporary cash investments in highly rated financial instruments and financial institutions and by policy, limits the amount of credit exposure to any one financial institution. The Company's investment policy limits its exposure to concentrations of credit risk.

The Company would be exposed to credit risk if a counterparty to a call option contract or the forward component of a foreign exchange swap contract were to fail to meet its contractual obligation, in which situation the Company would be required to replace the contract at market rate. The Company believes that the risk of financial loss due to the inability of counterparties to meet their obligation is remote and that any such loss would not be material to the results of operations of the Company. The Company minimizes its risk exposure from foreign exchange swaps and purchased call options by limiting counterparties to carefully selected major financial institutions.

The Company markets a substantial portion of its products to customers in the retail industry, a market in which a number of companies are highly leveraged. The Company continually evaluates the credit risk of these customers and believes that its allowances for doubtful accounts relative to its customer receivables are adequate.




Polaroid Corporation Annual Report 1996
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