Chapter 23 Mini-Case : The Economic Ordering Quantity (EOQ) model is a concise m

Question

Chapter 23 Mini-Case:

The Economic Ordering Quantity (EOQ) model is a concise method for maximizing the value of a company’s inventory. It allows managers to quickly assess the overall costs of their inventory by specifying the costs of both ordering and carrying inventory. While there are other, more in-depth methods of inventory evaluation, this model provides a solid overview of inventory-related costs. This Mini Case activity allows you to use the EOQ model to evaluate the inventory of a company and make recommendations based on your findings.

MINI CASE

Assume you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that specializes in creating exotic sauces from imported fruits and vegetables. The firm's CEO, Bill Stooksbury, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the pressing need for smaller companies to institute corporate risk management programs. Since no one at Tennessee Sunshine is familiar with the basics of derivatives and corporate risk management, Stooksbury has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and corporate risk management and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers. Please answer all questions h thru i as correctly and accurate as possible. Please!

h. Describe how commodity futures markets can be used to reduce input price risk.

i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-bond futures are trading at 111'25. What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%.

I need all question answered h thru i Please! Correctly and as accurate as possible. Like ASP!

Explanation / Answer

h. Describe how commodity futures markets can be used to reduce input price risk.

Answer: Essentially, the purchase of a commodity futures contract will allow a firm to make a future purchase of the input material at today's price, even if the market price on the good has risen substantially in the interim.

i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-bond futures are trading at 111'25. What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%.

Answer: If TS waits until June to issue its bonds, and if interest rates rise, then TS will have to pay a higher interest rate on its debt.
How much does that cost TS? One way to calculate the cost is to see how much the 20-year 7 percent semi-annual bonds that it intended to issue would be worth at the new discount rate of 8%.
Input N = 40, I/YR= 8/2, PMT = -5,000,000(7%/2) = 175,000, FV = -5,000,000
and solve for PV =$4,505,181.

Since they were going to be worth $5 million if they were issued immediately, then this represents a loss of $5,000,000 - $4,505,181 = $494,819.
TS can hedge this risk by selling T-bond futures contracts.The T-bond futures contracts are trading at 111 + 25/32 percent of par, or $111,781for a $100,000 contract value.

This means TS will need to sell 5,000,000/111,781 =44.7.
Because you must trade in whole contracts, TS will use 45 T-bond futurescontracts to hedge the bond position T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon,semiannual payment bond, and the 111-25 futures price translates to a $1,117.81 foreach $1000 face value bond.
The implied yield can be caluclated with a financial calculator to be (N = 40; Pmt = 30; FV = 1000; PV = -1117.81; calculate I/Y =2.5284% semi-annually, which is an annual rate of about 5.057%.
If interest rates increase by 1 percent, then the new yield on this underlying bond will be 6.057%.
The six month rate is 6.057%/2 = 3.0285%.
The corresponding price at this yield isfound by inputting N = 40, I/YR = 3.0285, PMT = -30, FV = -1000
and solving for PV = 993.44.

The value of each futures contract will be $99,344 at this higher interest rate.This represents a decrease of $111,781 – $99,344 = $12,437 for each contract.Since TShas sold futures contracts, this represents a profit to TS.The total profit from thefutures contracts is 45($12,437) = $559,665.
TS will lose $494,819 on the bonds it issues but gain $559,665 on its futures contracts. The net hedging gain is $559,665 - $494,819 = $64,846.

Thus TS will end up just a little bit better off if interest rates increase by 1%.

Note that if interest rates were to decrease instead, then TS would gain on the bonds itissues but lose on its futures contracts.

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