Operational Risk

Case: Delta Beverage, Inc.

 Operational risk
Machinery breaks down
Product market risk Products defects increase
Customer loss Weather destroys plant Input risk
Product obsolescence Inventory obsolesces Input prices increase
Competition increases Labor strikes
Product demand decreases Key employees leave
Supplier fails
Financial risk Total
Capital costs change
Exchange rate changes Firm Risk Tax risk
Inflation Income tax increases
Covenant violation Industrial revenue bonds end
Default on debt Sales tax increases
Regulatory risk
Legal risk Environmental laws change
Product liability Stricter antitrust enforcement
Restraint of trade charges Price supports end
Shareholder lawsuits Import protection ceases
Employee discrimination lawsuits
Risk Identification
Risk Measurement
 Measuring Risk
Mapping risk to firm’s Characterizing and
earnings or cash flow quantifying exposure

Earnings or Cash flow Exposure to Market

impact of change in Variable = (D Cash
variable = change in flow or D Earnings/
variable x exposure D Market Variable)
 Sensitivity Analysis for the Change in Cost of Aluminum
1994 5% 10% 15% 20%
Base Case Increase Increase Increase Increase
%growth rate approximates the 1991 and 1992 growth in net sales While
growth rates for 1989 and 1993 were much higher, the competitiveness of
Net sales (4% increase over 1993) $2,40,455 $2,40,455 $2,40,455 $2,40,455 $2,40,455
the bottling industry suggests that a more modest assumption for 1994 is
appropriate
COGS (67.5% of sales) $1,62,259 1,62,259 $1,62,259 $1,62,259 $1,62,259
COGS without aluminum $1,10,653 $1,10,653 $1,10,653 $1,10,653 $1,10,653
Net revenues attributable to aluminum cans: 60% COGS for cans: 73% of
sales COGS due to the cost of the can (Ex. 9): 49% Expected cost of
Aluminum costs $51,607 $54,187 $56,767 $59,347 $61,928
aluminum cans for Delta in 1994 = 60% x $240.5 million x 73% x 49% = $51.6
million
Gross margin $78,196 $75,616 $73,035 $70,455 $67,875
Consistent with information stated, and is only slightly lower than the 1993
Gross margin (%) 32.50% 31.40% 30.40% 29.30% 28.20%
margin, 32.9%
Average SG&A/sales for 1989–1993 is 25.4%, but the ratio for 1993 is 24.8%,
SG&A (25% of sales; 1989–1993 average) $60,114 $60,114 $60,114 $60,114 $60,114
making 25%a reasonable estimate
Operating earnings $18,082 $15,502 $12,922 $10,341 $7,761
Operating margin (%) 7.50% 6.40% 5.40% 4.30% 3.20%
EBITDA (operating profit + $7,162 – depreciation on 1993
$25,244 $22,664 $20,084 $17,503 $14,923
cash flow statement)
EBITDA change from base case −10% −20% −31% −41%

Cash interest (1993 cash flow statement) $11,664 $11,664 $11,664 $11,664 $11,664 Remain at their 1993 levels
Cash interest coverage 2.16 1.94 1.72 1.5 1.28
Pretax income $6,418 $3,838 $1,258 ($1,323) ($3,903)
Change from base case −40% −80% −121% −161%
 Sensitivity Analysis for the Change in Cost of PET
1994 5% 10% 15% 20%
Base Case Increase Increase Increase Increase
% growth rate approximates the 1991 and 1992
growth in net sales

Net sales (4% increase over 1993) $240,455 $240,455 $240,455 $240,455 $240,455 While growth rates for 1989 and 1993 were much
higher, the competitiveness of the bottling industry
suggests that a more modest assumption for 1994 is
appropriate
COGS (67.5% of sales) $162,259 $162,259 $162,259 $162,259 $162,259
COGS without PET $149,856 $149,856 $149,856 $149,856 $149,856
Net revenues: 26%
COGS: 62%
PET costs $$12,404 $13,024 $13,644 $14,264 $14,884 Cost of the bottle: 32%
Expected cost of bottle for Delta in 1994 = 26% x $240.5
million x 62% x 32% = $12.4 million
Gross margin $78,196 $77,576 $76,956 $76,336 $75,715
Consistent with information stated, and is only slightly
Gross margin (%) 32.50% 32.30% 32.00% 31.70% 31.50%
lower than the 1993 margin, 32.9%
Average SG&A/sales for 1989–1993 is 25.4%, but the
SG&A (25% of sales, 1989–1993 average) $60,114 $60,114 $60,114 $60,114 $60,114 ratio for 1993 is 24.8%, making 25% a reasonable
estimate
Operating profit (EBIT) $18,082 $17,462 $16,842 $16,222 $15,602
Operating margin (%) 7.50% 7.30% 7.00% 6.70% 6.50%
EBITDA (operating profit + 1993 depreciation)1 $25,244 $24,624 $24,004 $23,384 $22,764
EBITDA change from base case −2% −5% −7% −10%

Cash interest (1993 cash flow statement) $11,664 $11,664 $11,664 $11,664 $11,664 remain at their 1993 levels
Cash interest coverage 2.16 2.11 2.06 2 1.95
Pretax income $6,418 $5,798 $5,178 $4,558 $3,938
Change from base case −10% −19% −29% −39%
 Sensitivity Analysis for the Change in the Cost of Fructose
1994 5% 10% 15% 20%
Base Case Increase Increase Increase Increase
%growth rate approximates the 1991 and
1992 growth in net sales While growth rates
for 1989 and 1993 were much higher, the
Sales $2,40,455 $2,40,455 $2,40,455 $2,40,455 $2,40,455
competitiveness of the bottling industry
suggests that a more modest assumption for
1994 is appropriate
Total COGS $1,62,259 $1,62,259 $1,62,259 $1,62,259 $1,62,259
COGS without fructose $1,44,472 $1,44,472 $1,44,472 $1,44,472 $1,44,472
Canned drinks have an 11% fructose cost
component and PET drinks have a 16%
Fructose costs $17,787 18,676 19,566 20,455 $21,344 fructose cost component =(60%x $240.5 x
73%x 11%) +(26%x $240.5 x 62%x 16%) =
$17.8 million
Gross margin $78,196 $77,307 $76,417 $75,528 $74,639
Consistent with information stated, and is
Gross margin (%) 32.50% 32.20% 31.80% 31.40% 31.00% only slightly lower than the 1993 margin,
32.9%
Average SG&A/sales for 1989–1993 is 25.4%,
SG&A (25% of sales, 1989–1993 average) $60,114 $60,114 $60,114 $60,114 $60,114 but the ratio for 1993 is 24.8%, making 25%a
reasonable estimate
Operating profit (EBIT) $18,082 $17,193 $16,304 $15,414 $14,525
Operating margin (%) 7.50% 7.20% 6.80% 6.40% 6.00%
EBITDA (operating profit + 1993 depreciation) $25,244 $24,355 $23,466 $22,576 $21,687
EBITDA change from base case −4% −7% −11% −14%

Cash interest (1993 cash flow statement) $11,664 $11,664 $11,664 $11,664 $11,664 remain at their 1993 levels
Cash interest coverage 2.16 2.09 2.01 1.94 1.86
Pretax income $6,418 $5,529 $4,640 $3,750 $2,861
Change from base case −14% −28% −42% −55%
 10% increase in the cost of cans results in a 20%
Delta’s EBITDA is reduction in EBITDA
most sensitive to
the cost of
aluminum cans
10% increase in PET costs, EBITDA falls 5%,
and least sensitive
to PET changes 10% rise in the cost of fructose reduces EBITDA by
7%

For the base case and stay above the required 2.0 level
Interest for most of the cost scenarios considered

Coverage If aluminum rises even 5.0%, covenant is violated

Ratio Aluminum can rise no more than 3.8% before the

coverage ratio falls below 2.0 
 Sensitivity vs. Exposure

Can: 30.4% Not only that Delta’s profits

are highly sensitive to the cost
Volatilities of the of aluminum cans but also that
underlying PET: 3.7%
commodities aluminum is by far the most
likely commodity to have a
Fructose: large change in price
13.3%

Delta’s overall exposure is much greater for aluminum cans than for
the other cost components

Hence, aluminum cans are the best area to focus Delta’s hedging
efforts
Risk Management
Moderating Risk

Diversification Hedging

Mitigate
through
Insurance
Business
Activity
Mitigating
through
Business
Activity?
Hedging
Should hedge
all the Over hedging vs. Under hedging
expected
production for
the next 12 Risk retention
months?

Futures Linear vs. Non linear

Expected direction in movement
or Accuracy in sales estimate
Options? Cost of hedging
Futures
or
Options?
Managers are in the best position to understand the Hedging is likely to be more expensive
company and the exposures it faces - should
than it might appear, and, without
consider risk management as a fundamental task
they should perform so that individual investors do significant benefits, such expense may not
not have to perform it be justifiable

Equal chance of benefiting or of losing from

Reduce the probability of hedging in the market
Hedging program also requires a new
failure. infrastructure, including a settlement system, a
back office, and a supervising committee

Hedging should reduce the Investors know that commodity risks are
part of the bottling business - do not like
volatility of future cash flows -
YES those risks, investors NO
can go to the LME
reduces cost of capital market to do their own hedging

Aluminum risks could be

removed, leaving investor with Basis risk
bottling business risk

Hedging
 Price of an aluminum Cost of an aluminum can Price of a finished good
Basis can is not 100%
correlated with the
need not be strongly
correlated with the cost
often lags the price
changes of the inputs
LME price has of raw aluminum used to produce it
Risk
Price changes of an
Delta is exposed to the Margins may vary aluminum can are only
combination of aluminum
cost and the margins on for any number of weakly correlated with
changes in the price of raw
Must buy aluminum cans reasons aluminum

aluminum cans
rather than raw If the correlation is weak, could
easily be create more volatility by
trying to hedge aluminum when,
aluminum in reality, wants to hedge the cost
of aluminum cans
through
HEDGING
 Corporate Risk Spectrum
Risk Management Tools
On-Balance-Sheet
Risk Exposure Off-Balance-Sheet Financial Production
Firm specific Fire Insurance Convertible bonds Loss preventiona nd control
Lawsuit Warrants Hybrids Joint ventures
Payoffs from R&D projects Forwards Dual currency bonds Technology choice
Commodity prices Futures Oil indexed notes plant shifting
FOREX rates Swaps vertical integration
Marketwide Interest rates Options
Volatile Pre-Tax
Income and
Corporate Risk
Management
Derivatives Do Not Shift Risks from Place to
Place; Reduces Total Risk in the System

Expsoure Profile for an Oil Resources Company Expsoure Profile for a Petro Chemical Company

V Core Oil Business V Hedge

 P (Oil)  P (Oil)

Net Expsoure

Core Business
 Firms with No significant relation Firms with lower Higher probability
growth option between hedging and credit rating use of distress more

Empirical hedge more leverage more swap hedging

Findings Large firms

hedge more
More the tax
convexity; higher
the hedging
Closely held
firms buy more
reinsurance