Question

CASE APPLICATION Great West States (GWS) is a railroad company operat- ing in the Western United States. Juanita Salazar is risk manager of GWS. At the direction of the company's chief executive officer, she is searching for ways to handle the company's risks in a more cconomical way. The CEO stressed that Juanita should consider not only pure risks but also financial risks. Juanita discovered that a signifi- cant financial risk facing the organization is a commod- ity price risk-the risk of a significant increase in the price of fuel for the company's locomotives. A review of the company's income and expense statement showed that last year about 28 percent of its expenses were related to fuel oil. Juanita was also asked to determine whether the installation of a new sprinkler system at the corporate headquarters building would be justified. The cost of the project would be $40,000. She estimates the project would provide an after-tax net cash flow of $25,000 per year for three years, with the first of these cash flows coming one year after investment in the project. The company is considering expanding its routes to include Colorado, New Mexico, Texas, and Oklahoma It is concerned about the number of derailments that might occur. Juanita ran a regression with thousands of miles GWS locomotives travelled" as the independent variable and number of derailments" as the dependent variable. Results of the regression are as follows: Y - 2.31 + .022X With the expansion, GWS trains will travel an estimated 640,000 miles next year. a. With regard to the fuel price risk: 1. Discuss how Juanita could use futures contracts to hedge the price risk 2. Discuss how a double-trigger, integrated risk man- agement plan could be employed. (Continued)

Answer 1

ANSWER: Part A) Juanita is expecting fuel price to rise considerably, she can go through into a future contract to lock the purchase price of fuel with the counter party. As future contract will lock the future price now only, it will help her to be cautious the price risk. In this way, she will know the price company will be required to pay for fuel in advance only as the price will be determined by future contract. Part B Discounting $ 40000 cash outflow and $25000 cash inflow for next three years at rate of 10%, we get: Present Value of Cash Flow at T=0: -40000/ (1.140) = -$40000 Present Value of Cash Flow at T=1: 25000/ (1.1^1) = $22727.27 Present Value of Cash Flow at T=2: 25000/ (1.1^2) = $20661.16 Present Value of Cash Flow at T=3: 25000/ (1.1^3) = $18782.87 NPV will be given by adding all present values. NPV =-$40000 + $22727.27+$20661.16+ $18782.87 = $22171.3

Therefore; NPV is $22171.3 Part-C) Derailments are given by regression equation: Y=2.317.022x Where, Y is number of derailments X is thousands of miles GREAT WEST STATES (GWS) locomotives travelled Now, as per expansion plan, X = 640000 Y=2.31 +(0.22*640000) = 140800 +2.31 = 140802.31 = 140802 Therefore; Number of derailments expected is approximately 140802