see last two pictures for the question

choose to hedge 100% or 50% or no hedge and explain why

- Your company is a producer of commodity X. The fragment of price history for this commodity is on the next slide. - Today is 8/16/1973. You have a contract to sell 100,000 units of the commodity to a customer on 11/29/1973 at the spot price - The price of the commodity right now is $45.50 - Your risk management department is charged with the decision: to hedge or not to hedge. 8/16/73 $45.50 - Your company has total assets of $100 million, financed with 25% debt at the interest rate of 4%, and 75% equity. - Your operating costs are $2 million. - Your interest payment due is $10025%4%=$1 million - To cover the costs and still be able to make the interest payment, you need minimum revenue of $2+$1=$3 million. - Should you have less than minimum revenue, you will go bankrupt. Recovering from bankruptcy would cost you 20% of assets, or $20 million. Company Financials: Investment - Your company is financially constrained due to poor credit rating and will need to finance its investments with internal cash flow. - There is a lucrative investment opportunity, which will generate cash flow of $1 million per year for 20 years. Discounted as an annuity at the company's WACC of 7.75%, Present Value of those future cash flows is $10 million. However, the investment requires initial CAPEX of $3 million. The NPV is $10$3=$7 million, which would increase the company's asset value. - To cover CAPEX, operating costs, and the interest payment on debt, your revenue should be $3+ $2+$1=$6 million. If your revenue is less, you cannot make the investment, in full or in part. The Choice - If you want to stay exposed to the spot market price, choose A. - If you want to fix the net price at $45.25 for at least some of your production, choose B. - Remember that if the price turns out to be above $45.25, you will lose on the hedge (without the hedge, you would have received a better price) - But if the price turns out to be below $45,25, you will gain on the hedge (without the hedge, you would have received a worse price) - Suppose you hedge 50,000 units, and the spot price on 11/29/1973 turns out $50 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $50+50,000=$2,500,000 to the swap dealer Receive $45.2550,000=$2,262,500 from the swap dealer - Lost on the swap: ($2,262,500$2,500,000)=$237,500 - Spot revenue from the customer: 100,000$50=$5,000,000 - Total revenue: $5,000,000$237,500=$4,762,500 - Suppose you hedge 50,000 units, and the spot price on 11/29/1973 turns out $40 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $4050,000=$2,000,000 to the swap dealer Receive $45.2550,000=$2,262,500 from the swap dealer - Gained on the swap: (2,262,5002,000,000)=$262,500 - Spot revenue from the customer: 100,000$40=$4,000,000 - Total revenue: $4,000,000+$262,500=$4,262,500 - Suppose you hedge 100,000 units, and the spot price on 11/29/1973 turns out $50 - If you choose option B (sell the swap to the dealer at the bid \$45.25), then you will Pay $50100,000=$5,000,000 to the swap dealer Receive $45.25100,000=$4,525,000 from the swap dealer - Lost on the swap: ($4,525,000$5,000,000)=$475,000 - Spot revenue from the customer: 100,000$50=$5,000,000 - Total revenue: $5,000,000$475,000=$4,525,000 Example: 100% Hedge - Suppose you hedge 100,000 units, and the spot price on 11/29/1973 turns out $40 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $40100,000=$4,000,000 to the swap dealer Receive $45.25100,000=$4,525,000 from the swap dealer - Gained on the swapi (4,525,0004,000,000)=$525,000 - $ pot revenue from the customer: 100,000$40=$4,000,000 - Total revenue: $4,000,000+$525,000=$4,525,000 - Make the choice, A or B. If you choose B, then specify the number of units hedged. - Explain your rationale for the choice. - Please turn in your response electronically on Blackboard in any desired format by the deadline. - If the choice is not clearly made (e.g., if you say "hedge" but do not specify the number of units), the assignment will not be accepted, and will need to be resubmitted within 48 hours with late penalty - Provided you indicated your Trader ID and made a clear choice, the assignment will be graded based on the reasoning for your decision. Your financial performance in the game will not impact grading. - Please note that I am not looking for a "correct" answer. There is no correct answer to this problem. - Your company is a producer of commodity X. The fragment of price history for this commodity is on the next slide. - Today is 8/16/1973. You have a contract to sell 100,000 units of the commodity to a customer on 11/29/1973 at the spot price - The price of the commodity right now is $45.50 - Your risk management department is charged with the decision: to hedge or not to hedge. 8/16/73 $45.50 - Your company has total assets of $100 million, financed with 25% debt at the interest rate of 4%, and 75% equity. - Your operating costs are $2 million. - Your interest payment due is $10025%4%=$1 million - To cover the costs and still be able to make the interest payment, you need minimum revenue of $2+$1=$3 million. - Should you have less than minimum revenue, you will go bankrupt. Recovering from bankruptcy would cost you 20% of assets, or $20 million. Company Financials: Investment - Your company is financially constrained due to poor credit rating and will need to finance its investments with internal cash flow. - There is a lucrative investment opportunity, which will generate cash flow of $1 million per year for 20 years. Discounted as an annuity at the company's WACC of 7.75%, Present Value of those future cash flows is $10 million. However, the investment requires initial CAPEX of $3 million. The NPV is $10$3=$7 million, which would increase the company's asset value. - To cover CAPEX, operating costs, and the interest payment on debt, your revenue should be $3+ $2+$1=$6 million. If your revenue is less, you cannot make the investment, in full or in part. The Choice - If you want to stay exposed to the spot market price, choose A. - If you want to fix the net price at $45.25 for at least some of your production, choose B. - Remember that if the price turns out to be above $45.25, you will lose on the hedge (without the hedge, you would have received a better price) - But if the price turns out to be below $45,25, you will gain on the hedge (without the hedge, you would have received a worse price) - Suppose you hedge 50,000 units, and the spot price on 11/29/1973 turns out $50 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $50+50,000=$2,500,000 to the swap dealer Receive $45.2550,000=$2,262,500 from the swap dealer - Lost on the swap: ($2,262,500$2,500,000)=$237,500 - Spot revenue from the customer: 100,000$50=$5,000,000 - Total revenue: $5,000,000$237,500=$4,762,500 - Suppose you hedge 50,000 units, and the spot price on 11/29/1973 turns out $40 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $4050,000=$2,000,000 to the swap dealer Receive $45.2550,000=$2,262,500 from the swap dealer - Gained on the swap: (2,262,5002,000,000)=$262,500 - Spot revenue from the customer: 100,000$40=$4,000,000 - Total revenue: $4,000,000+$262,500=$4,262,500 - Suppose you hedge 100,000 units, and the spot price on 11/29/1973 turns out $50 - If you choose option B (sell the swap to the dealer at the bid \$45.25), then you will Pay $50100,000=$5,000,000 to the swap dealer Receive $45.25100,000=$4,525,000 from the swap dealer - Lost on the swap: ($4,525,000$5,000,000)=$475,000 - Spot revenue from the customer: 100,000$50=$5,000,000 - Total revenue: $5,000,000$475,000=$4,525,000 Example: 100% Hedge - Suppose you hedge 100,000 units, and the spot price on 11/29/1973 turns out $40 - If you choose option B (sell the swap to the dealer at the bid $45.25 ), then you will Pay $40100,000=$4,000,000 to the swap dealer Receive $45.25100,000=$4,525,000 from the swap dealer - Gained on the swapi (4,525,0004,000,000)=$525,000 - $ pot revenue from the customer: 100,000$40=$4,000,000 - Total revenue: $4,000,000+$525,000=$4,525,000 - Make the choice, A or B. If you choose B, then specify the number of units hedged. - Explain your rationale for the choice. - Please turn in your response electronically on Blackboard in any desired format by the deadline. - If the choice is not clearly made (e.g., if you say "hedge" but do not specify the number of units), the assignment will not be accepted, and will need to be resubmitted within 48 hours with late penalty - Provided you indicated your Trader ID and made a clear choice, the assignment will be graded based on the reasoning for your decision. Your financial performance in the game will not impact grading. - Please note that I am not looking for a "correct" answer. There is no correct answer to this