Question 2.4: Consider a chocolate maker that will need 10,000 tons of coc...
Consider a chocolate maker that will need 10,000 tons of cocoa beans next year. The current market price of cocoa beans is $2900 per ton. At this price, the firm expects earnings before interest and taxes of $44 million next year. What will the firm’s EBIT be if the price of cocoa beans rises to $3500 per ton? What will EBIT be if the price of cocoa beans falls to $2600 per ton? What will EBIT be in each scenario if the firm enters into a supply contract for cocoa beans for a fixed price of $2950 per ton?
Plan
At $2900 per ton, the firm’s EBIT is $4 million. For every dollar above $2900 per ton, its EBIT will decrease by $10,000 (for 10,000 tons) and similarly will increase by $10,000 for every dollar below $2900 per ton.
Execute
At $3500 per ton, the firm’s costs will increase by (3500 – 2900) × 10,000 = $6 million. Other things being equal, EBIT will decline to $44 million – $6 million = $38 million.
If the price of cocoa beans falls instead to $2600 per ton, EBIT will rise to $44 million – (2600 – 2900) × 10,000 = $47 million.
Alternatively, the firm can avoid this risk by entering into the supply contract that fixes the price in either scenario at $2950 per ton, for an EBIT of $44 million – (2950 – 2900) × 10,000 = $43.5 million.
Evaluate
The firm can completely reduce its risk by entering into the supply contract. The cost is accepting lower (by $500,000) operating income for certain.