The Jones Family Incorporated

The Scene: It is early evening in the summer of $2018,$ in an ordinary family room in Manhattan. Modern furniture, with old copies of The Wall Street Journal and the Financial Times scattered around. Autographed photos of Jerome Powell and George Soros are prominently displayed.

A picture window reveals a distant view of lights on the Hudson River. John Jones sits at a computer terminal, glumly sipping a glass of chardonnay and putting on a carry trade in Japanese yen

over the Internet. His wife Marsha enters.

Marsha: Hi$,$ honey. Glad to be home. Lousy day on the trading floor, though. Dullsville. No volume. But I did manage to hedge next year$$s production from our copper mine. I couldn$$t get a

good quote on the right package of futures contracts, so I arranged a commodity swap.

John doesn$$t reply.

Chapter $9$ Risk and the Cost of Capital $255$

Marsha: John, what$$s wrong? Have you been selling yen again? That$$s been a losing trade for

weeks.

John: Well, yes. I shouldn$$t have gone to Goldman Sachs$$s foreign exchange brunch. But I$$ve

got to get out of the house somehow. I$$m cooped up here all day calculating covariances and

efficient risk$-$return trade$-$offs while you$$re out trading commodity futures. You get all the

glamour and excitement.

Marsha: Don$$t worry, dear, it will be over soon. We only recalculate our most efficient common

stock portfolio once a quarter. Then you can go back to leveraged leases.

John: You trade, and I do all the worrying. Now there$$s a rumor that our leasing company is going

to get a hostile takeover bid. I knew the debt ratio was too low, and you forgot to put on the

poison pill. And now you$$ve made a negative$-$NPV investment!

Marsha: What investment?

John: That wildcat oil well. Another well in that old Sourdough field. It$$s going to cost $$5$ million!

Is there any oil down there?

Marsha: That Sourdough field has been good to us$,$ John. Where do you think we got the capital for

your yen trades? I bet we$$ll find oil. Our geologists say there$$s only a $30\%$ chance of a dry hole.

John: Even if we hit oil, I bet we$$ll only get $75$ barrels of crude oil per day.

Marsha: That$$s $75$ barrels day in$,$ day out. There are $365$ days in a year, dear.

John and Marsha$$s teenage son Johnny bursts into the room.

Johnny: Hi$,$ Dad! Hi$,$ Mom! Guess what? I$$ve made the junior varsity derivatives team! That

means I can go on the field trip to the Chicago Board Options Exchange. $($Pauses$.)$ What$$s

wrong?

John: Your mother has made another negative$-$NPV investment. A wildcat oil well, way up on the

North Slope of Alaska.

Johnny: That$$s OK$,$ Dad. Mom told me about it$.$ I was going to do an NPV calculation yesterday,

but I had to finish calculating the junk$-$bond default probabilities for my corporate finance

homework. $($Grabs a financial calculator from his backpack.$)$ Let$$s see: $75$ barrels a day times

$365$ days per year times $$100$ per barrel when delivered in Los Angeles $...$ that$$s $$2\mathrm{.}7$ million

per year.

John: That$$s $$2\mathrm{.}7$ million next year, assuming that we find any oil at all. The production will

start declining by $5\%$ every year. And we still have to pay $$20$ per barrel in pipeline and tanker

charges to ship the oil from the North Slope to Los Angeles. We$$ve got some serious operating

leverage here.

Marsha: On the other hand, our energy consultants project increasing oil prices. If they increase

with inflation, price per barrel should increase by roughly $2\mathrm{.}5\%$ per year. The wells ought to be

able to keep pumping for at least $15$ years.

Johnny: I$$ll calculate NPV after I finish with the default probabilities. The interest rate is $6\%.$

Is it OK if I work with the beta of $\mathrm{.}8$ and our usual figure of $7\%$ for the market risk premium?

Marsha: I guess so$,$ Johnny. But I am concerned about the fixed shipping costs.

John: $($Takes a deep breath and stands up$.)$ Anyway, how about a nice family dinner? I$$ve reserved

our usual table at the Four Seasons.

Everyone exits.

Announcer: Is the wildcat well really negative$-$NPV$?$ Will John and Marsha have to fight a hostile

takeover? Will Johnny$$s derivatives team use Black$$Scholes or the binomial method? Find out

in the next episode of The Jones Family Incorporated.

$256$ Part Two Risk

You may not aspire to the Jones family$$s way of life, but you will learn about all their acti

$1.$ Calculate the NPV of the wildcat oil well, taking account of the probability of a dry hole, the

shipping costs, the decline in production, and the forecasted increase in oil prices. How long

does production have to continue for the well to be a positive$-$NPV investment? Ignore taxes

and other possible complications.

$2.$ Now consider operating leverage. How should the shipping costs be valued, assuming that

output is known and the costs are fixed? How would your answer change if the shipping costs

were proportional to output? Assume that unexpected fluctuations in output are zero$-$beta

and diversifiable. $($Hint: The Jones$$s oil company has an excellent credit rating. Its long$-$termborrowing rate is only $7\%.)$