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J&L Railroad

BACKGROUND

Many railroad firms within the United States has begun to experience profits that are not at a point of maximization because of the increase fuel costs they must incur. With severe prices competition firms are not able to increase prices in response to increased costs because of consumers changing behavior in direct response to prices changes. Although some firms have discussed adjusting prices in response to fuel costs, they have not taken this action. In result of this decrease in potential profit, firms are beginning to explore potential ways to decrease the risk associated with the volatility of fuel costs, so they can increase and maximize the profit. J&L Railroad in particular is exploring the avenue of hedging. CFO, Jeannine Mathews has been researching potential hedging alternatives to present to the Board of J&L Railroads. Mathews and J&L Railroad must decide is hedging is the best option for the company and its shareholders, and if so, how much they should hedge, and in what manner should implement the hedging.

J&L RAILROAD

J&L Railroad was founded in 1928 and although publically owned, is one of only a few Class I railroads still manger by the original founding families. Along with many other firms within the industry, J&L has invested large amounts of capital in order to increase efficiency within the company. This has included, replacing equipment, repairing railways and building lighter railroad cars. Although these contributions have helped decrease prices in the long run, the firm still has seen lowering of potential profit due solely to the increasing fuel costs and the inability to increase prices. In 2001, total fuel costs were 6.7% of revenues. This cost has increased constantly since then, accounting for 16.3% of revenues in 2008. Focusing on 2008, the company saw an increase in rail revenues of $154 million, but operating margin had decreased by $114 million. The firm experienced a decrease in operating profit of 11% 2008 – which followed an increase of 9% the year prior. Faced with these financial issues, the firm began to thoroughly examine the opportunity of hedging.

ALTERNATIVES

The company can decide to not partake in hedging and simply absorb the rising fuel costs with the hopes that eventually the industry will increase overall prices to try and combat the increasing fuel costs. In the past the firm has tried to enter into fixed price fuel contracts with suppliers, however these have not been financially benefitting because of produces defaulting on the contracts.

By taking the action of hedging, the firm will take action to try and minimizing fuel costs risk. There are two alternatives proposed by Mathews and one other that she did not evaluate. The three alternatives are as follows:

1) NYMEX: J&L can offset exposure to fuel cost risk by entering into heating oil futures and options. NYMEX does not trade contracts on diesel fuel, however heating oil prices are greatly correlated with diesel fuel prices.

  • Futures: J&L would be able to buy heating oil at a future date set at a predetermined price. The futures market expects spot price of to increase from an average of $1.36 to $1.52 over the next 12 months.
  • Options: Call option gives J&L opportunity to go long on the heating oil at a strike price on or before expiration date. While a put option gives them the opportunity to go short on the futures at a strike price. Options require a premium to be paid, which J&L has the potential of losing if the price does not move in the desired direction.

2) Kansas City National Bank: Offers numerous services that emulate the NYMEX actions, for a fee. These products include, commodity swaps, caps, floors, and collars. These hedge the average price of heating oil during the contract period.

  • Swap: Bank pays on settlement date is average price of heating oil is above agreed upon price, and J&L pays if it is below. KCNB now carries the credit risk.
  • Cap: Essentially a call option (while floor is a put option). KCNB agrees to pay the excess of the realized average fuel price, over the strike price. J&L would be required to pay a premium for the cap. A cap allows for J&L to be protected from price increases above the strike price, and still take advantage of price decreases.
  • Collar: Combination of call and put. KCNB agreed to pay the excess of the heating oil price over the strike price, with J&L agreeing to pay if the average price is below the floor strike price. This would guard against prices rising over a certain call strike price, but at the same time may reduce the potential gains because of giving up benefit if the price falls below the floor strike price.

3) Asian Options: Give J&L the ability to exercise on predetermined dates, prior to maturity. These options actually reduce the risk of market manipulations because the payoff is determined by the average underlying price, as oppose to American options in which the payoff is solely determined by the price of the asset at maturity.

RECCOMENDATION

After both conceptual and financial observation, I recommend that J&L does indeed partake in hedging actions. Options contracts have helped many corporations reduce exchange rate risk, which not only benefits the firm but the shareholders. I believe that with the correct actions, J&L will be able to hedge successfully, increasing profits and increasing the return to shareholders. I think that the best way to do this is to enter into a relationship with KCNB. The NYMEX comes with too many risks and challenges. These include, not being knowledgeable in the field, which comes hand in hand with potential to enter into contracts without the accurate prior information. Additionally, NYMEX future contracts are set at 42,000 gallons per month; J&L is unlikely to always need a multiple of 42,000 gallons. Utilizing KCNB will enable J&L to focus their attention on the field they are knowledgeable and professionals in, leaving the investment strategies up to investment professionals. Although there are upfront fees to use KCNB, the products offered will provide J&L many ways to hedge their diesel-fuel cost risks. I think that during the first year of hedging, J&L should hedge 60% of their costs. This will enable to the firm to experience the potential benefits of hedging, without putting themselves at too much of risk.

CONCLUSION

It would be at the best interest of the firm and of its shareholders, if J&L hedges 60% of their fuel cost, using KCNB products. This will enable to the company to experience higher profits and rid of some of the risk associated with the volatility of diesel fuel prices.

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