The Sweet Tooth Candy Company knows it will need 10 tons of sugar six months fro

Question

The Sweet Tooth Candy Company knows it will need 10 tons of sugar six months from now to implement its production plans. The company has essentially two options for acquiring the needed sugar. It can either buy the sugar at the going market price when it is needed, six months from now, or it can buy a futures contract now. The contract guarantees delivery of the sugar in six months but the cost of purchasing it will be based on today's market price. Assume that possible sugar futures contracts available for purchase are for five tons or ten tons only. No futures contracts can be purchased or sold in the intervening months. Thus, Sweet Tooth's possible decisions are to (1) purchase a futures contract for ten tons of sugar now, (2) purchase a futures contract for five tons of sugar now and five tons of sugar in six months, or purchase all ten tons of needed sugar in six months. The price of sugar bought now for delivery in six months is $0.0851 per pound. The transaction costs for five-ton and ten-ton futures contracts are $65 and $110, respectively. Finally, the company has assessed the probability distribution for the possible prices of sugar six months from now (in dollars per pound). The file P06_30.xlsx contains these possible prices and their corresponding probabilities.

a. Use PrecisionTree to identify the decision that minimizes SweetTooth's expected cost of meeting its sugar demand.

b. Perform a sensitivity analysis on the optimal decision, letting each of the three currency inputs vary one at a time plus or minus 25% from its base value, and summarize your findings. Which of the inputs appears to have the largest effect on the best decision?

Distribution of price in 6 months: Price Probability

$0.078 0.05

$0.083 0.25

$0.087 0.35

$0.091 0.20

$0.096 0.15

Explanation / Answer

Solution:

a) Opportunity cost matrix:

If the company decides to buy at market rate, the value of contract will be:

=10*1,000*$0.0851

=851 pounds

b) If the company decides to buy futures, the cost would be:

=10*1,000*$0.096

=960 pounds

Note:

In futures, in addition to the purchase cost there is transaction cost of $110.Hence, it is viable for the company to buy sugar now which will be delivered in 6 months.

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