Please see the attached for an outline of my inquiries. Thank you. Document Preview: Hedging with forward contracts) The Specialty Chemical Company operates a crude oil refinery located in New Iberia,...

1)
1) Hedging with forward contracts)
The Specialty Chemical Company operates a crude oil refinery located in New Iberia, LA . The company refines crude oil and sells the by-products to companies that make plastic bottles and jugs. The firm is currently planning for its refining needs for one year hence. Specifically, the firm’s analysts estimate that Specialty will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feed stock for its refining needs for the coming year. The 1 million barrels of crude will be converted into by-products at an average cost of $15 per barrel that Specialty expects to sell for $170 million, or 4170 per barrel of crude used. The current spot price of oil is $115 per barrel and Specialty has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $120 per barrel.
a) Ignoring taxes, what will Specialty’s profits be if oil prices in one year are as low as $100 or as high as $140, assuming that the firm does not enter into the forward contract? (Round to the nearest dollar)
Price of Oil/bbl
Unhedged Annual Profits
$100 $ __________________
$105 $ __________________
$110
$ ___________________
$115
$ ___________________
$120 $ ___________________
$125
$ ___________________
$130
$ ___________________
$135
$ ___________________
$140
$ ___________________
Solution:
    Price of Oil/bbl
A
    Total cost of oil
B
=A*1m
    Total revenues
C
=$170*lm
    Total refining costs
D
=$15*lm
    Unhedged annual profits
E
=C-B-D
    
    
    100
    100,000,000
    170,000,000
    15,000,000
    55,000,000
     
     
    105
    105,000,000
    170,000,000
    15,000,000
    50,000,000
     
     
    110
    110,000,000
    170,000,000
    15,000,000
    45,000,000
     
     
    115
    115,000,000
    170,000,000
    15,000,000
    40,000,000
     
     
    120
    120,000,000
    170,000,000
    15,000,000
    35,000,000
     
     
    125
    125,000,000
    170,000,000
    15,000,000
    30,000,000
     
     
    130
    130,000,000
    170,000,000
    15,000,000
    25,000,000
     
     
    135
    135,000,000
    170,000,000
    15,000,000
    20,000,000
     
     
    140
    140,000,000
    170,000,000
    15,000,000
    15,000,000
    
    
b) If the firm were to enter into the forward contract, demonstrate how this would effectively lock in the firm’s cost of fuel today, thus hedging the risk of fluctuating crude oil prices on the firm’s profits for the next year.
Answer:
When the price of crude oil is not hedged, the firm’s profit vary from $15 million to $55 million. Hence, the firm’s profit are completely hedged as the profits are always $15 million.
2) Margin requirements and marking to market
Discuss how the exchange requirements that mandate traders to put up collateral in the form of a margin requirement and to use this account to mark their profits or losses for the day serve to eliminate credit or default risk.
· Because (neither party has OR both parties have) to post margin when they enter into a futures contract and because they mark to market (everyday until the delivery date OR on the delivery date), we are (not assured OR assured) the party and the counterparty to the contract have already posted the gain or loss to the other and the risk of default (is thereby negated OR still exists).
Answer:
Because (both parties have) to post margin when they enter into a futures contract and because they mark to market (on the delivery date), we are (not assured OR assured) the party and the counterparty to the contract have already posted the gain or loss to the other and the risk of default (is thereby negated).
3) Forward contract payout
Construct a delivery date profit or loss graph for a short position in a forward contract with a delivery price of $55. Analyze the profit or loss values of the underlying asset ranging from $25 to $75.
Solution:
When the maturity price is $55, you break-even. When it falls below $55, there will be profit, otherwise it’s a loss.
4) Forward contract payout
Construct a delivery date profit or loss graph for a long position in a forward contract with a delivery price of $50. Analyze the profit or loss values of the underlying asset ranging from $20 to $75.
Solution:
For a long position, when the price exceeds $50, there will be positive payoff and when the price falls below $70, there will not be any profit. Hence, the loss is the call premium paid.
5) Individual or component cost of capital
Compute the cost of capital for the following:
a) A bond that has a $1000 par value (face value) and a contract or coupon interest rate of 11.3%. The bonds have a current market value of $1,125 and will mature in 10 years. The firm’s marginal tax rate is 34%.
· The cost of capital from this bond debit is ________%
Solution:
We have F = 1000, P = 1125, I = 0.113 x 1000 = 113 and n = 10
Using YTM approximation formula,
YTM = [I + (F – P)/n]/ (F + P)/2
= [113 + (1000 – 1125)/10]/ (1000 + 1125)/2
= [113 + (-12.5)]/1062.5
= 100.5/1062.5
= 0.093 or 9.3%
Cost of capital = YTM*(1 – tax rate)
= 9.3*(1-0.34)
= 6.14%
b) A new common stock issue that paid a $1.78 dividend last year. The firm’s dividends are expected to continue to grow at 7.8% per year forever. The price of the firm’s common stock is now $27.98.
Solution:
We have D1 = D0 (1+ g) = 1.78 (1.078) = $1.919, g = 0.078 and P0 = 27.98
Using constant growth model, we have
P0 = D1/ (k – g)
27.98 = 1.919/ (k-0.078)
K - 0.078 = 1.919/27.98
k=0.06858+0.078
k=0.1465 or 14.65%
c) A preferred stock paying a 9.8% dividend on a $135 par value.
Solution:
We have D = 0.098*$135 =13.23 and P0 = $135
k = D/P0
k= 13.23/135
k= 0.098 or 9.8%
d) A bond selling to yield 12.6% where the firm’s tax rate is 34%
Solution:
We have YTM = 12.6% and tax rate = 34%
Cost of Capital = YTM*(1-tax rate)
= 12.6*(1-0.34)
= 8.32%
6) Individual or component costs of capital
Your firm is considering a new investment proposal and would like to calculate its weighted average cost of capital. To help in this, compute the cost of capital for the firm for the following:
a) A bond that has a $1,000 par value (face value) and a contract or coupon interest rate of 12.5%. The bond is currently selling for a price of $1,127 and will mature in 10 years. The firm’s tax rate is 34%.
The cost of capital from this bond debit is ________%
Solution:
We have F = 1000, P = 1127, I = 0.125 x 1000 = 125 and n = 10
Using YTM approximation formula,
YTM = [I + (F – P)/n]/ (F + P)/2
= [125 + (1000 – 1127)/10]/ (1000 + 1127)/2
= [125 + (-12.7)]/1063.5
= 112.3/1063.5
= 0.104 or 10.4%
Cost of capital = YTM*(1 – tax rate)
= 10.4 %*(1-0.34)
=...