Great West States (GWS) is a railroad company operating 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 economical way. The CEO stressed that Juanita should consider not only pure risks but also financial risks. Juanita discovered that a significant financial risk facing the organization is a commodity 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 management plan could be employed.
B. What is the net present value (NPV) of the sprinkler system project, assuming the rate of return required by GWS investors is 10 percent?
C. How many derailments should Juanita expect next year, assuming the regression results are reliable and GWS goes ahead with the expansion plan?
(Note: Be careful of scale factors when considering the independent variable.)