5. Company A operates a gas turbine operation to generate electricity with payof

Question

5. Company A operates a gas turbine operation to generate electricity with payoffs depending on the price of natural gas, of $600 million (“good state”) or $400 million (“bad state”) in one year. Each of these outcomes occurs with equal probability. Assume that the firm can engage in a hedging program which provides a positive payoff of $100 million in the bad state and a payoff of -$100 million in the good state. The firm has a debt repayment of $450 million that comes due next year at the time the project payoff is realized. The debt holders only have recourse to the payoffs from the project to repay their debt. Managers run the firm on behalf of shareholders. (Ignore taxes.)

a) The hedge costs $3 million. Should the firm hedge its natural gas price risk? The criterion in this case is which of the two decisions (hedge or not) makes the shareholders better off. You will need to compute the expected payoff to the debt holders and separately the expected payoff to the shareholders.

b) How will your answer to “a)” change if the cost of the hedge is reduced to zero?

Explanation / Answer

Ans. a) If a firm decides not to hedge:

If a firm decides to Hedge :

Decision: It is better not to hedge as hedging decreases the net benefit.

b) If the cost of hedging reduced to 0 , then net benefit would be same i.e. $50 Million. So, it is indifference to do hedging or not.

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