Delta Beverage Group, Inc.

...

As shown in Table 2, both parameters stay above 1 during the entire period. It can be concluded that these are not a threat to the company’s financial position.

3. HEDGING

As mentioned earlier, a financial or operational hedge were considered. An operational hedge could contain the company having a higher production of bottles instead of cans, whereby DBG would increase profit, as gross margin of bottles was 12% higher than of cans. However, the company is tied to different market segments. Changing the structure of product mix would probably incur losing value-oriented customers. Substituting bottles for cans was therefore ruled out by Bierbaum. Thereby, DBG is a franchise of PepsiCo, Inc., which means the firm is not allowed to charge the customer by increasing the price of final products. Therefore, an operational hedge is ruled out.

Besides a financial hedge, the company can also decide not to take action and pay the regular market price. This results in DBG bearing the risk of price volatility. Several scenarios are forecasted to give insights on DGB’s exposure to aluminium prices. In Appendix 1 the current financial situation is calculated and forecasted without assuming price increases or futures contracts.

First, for annual price increases 20%, 15% and 10% are assumed. These are chosen to create different assumable scenarios. The details can be found in Appendix 2. The impact of different price increases specifically on the interest coverage ratio can be found in Table 3. The calculations show that the firm will still have an interest ratio of at least 2.0 when the price increases with 10% or 15%. However, when the price of aluminium will rise by 20%, the interest coverage ratio will clearly be too low. In this case, the firm will default on its debts. As the current annual price increase from 1993 until 1994 is already 30%, it is assumable that not hedging would have a negative effect on the company and its future.

To avoid possible negative effects, the company could obtain a financial hedge. In the case of DBG, the financial hedge appears as a futures contract. There are three scenarios, based on the duration of the futures contracts, namely 1) futures contract of three months 2) futures contract of fifteen months and 3) futures contract of 27 months. More details can be found in Appendix 3. Assumptions regarding the content and calculations will now be explained.

It is assumed that once the futures contract has ended (whether it is after three months or fifteen months), a price increase of 20% occurs. Therefore, the percentage of price increases are the average of the futures contract price during the amount of months and the price increase during the remaining months. In each scenario of hedging, the interest coverage ratio is above 2.0.

Table 3. Interest coverage ratios for the different scenarios

Price Changes

1994

1995

1996

10% Annual Price increase

1.88

2.41

2.52

15% Annual Price increase

1.88

2.18

2.53

20% Annual Price increase

1.88

1.12

1.25

Futures Contract 3M (20%)

1.88

2,16

2,25

Futures Contract 15M (20%)

1.88

2,58

2,91

Futures Contract 27M

1.88

2,47

3,62

4. ADVICE

Based on the given information, reasonable assumptions and calculations, an advice can be given to Mr Bierbaum. The current financial situation showed that changes of defaulting on debt has decreased, but the possibility of issuing new debt stays low. If costs will rise, it will have negative effects on net income and might become a threat to the company in the future.

Table 3 shows that the interest coverage ratio only drops below 2.0 in the case of an 20% increase. Since aluminium has a volatile past and 20% increases or more have happened before, it is assumable this event will occur again. Therefore, Mr Bierbaum is advised to purchase a financial hedge contract. A three months futures contract will still be risky. It is assumable that after the short contract finishes, the annual prices continues to increase, causing the interest coverage ratio to yet drop below 2.0. On the other hand, a 27 months futures contract has a high ratio which can result in inefficiency of funds. Furthermore, prices of aluminium could drop again in two years. Therefore, a 15 months aluminium futures contract will be most beneficial as it results in the most appropriate duration and interest coverage ratio.

Appendix

Appendix 1 Current situation

Appendix 2 Without futures contract

Appendix 3 With futures contract

Current Financial Position

(in thousands of U.S. dollars)

1989

1990

1991

1992

1993

Debt

165,751

162,310

164,264

172,185

...