Delta Beverage Group Inc.

Case

Executive Summary
Delta Beverage Group, Inc. is a famous bottling and canning company. Due to a price war, Delta
suffered from tight margins. To handle the situation a new management was appointed who
helped in reviving the market share and increased margins by changing the cost structure. Delta
also acquired some other bottling companies. This led to a rise in operating profits and their net
income. Yet their net income remained negative due to their high interest component. Hence,
they indulged in debt restructuring to avoid defaulting on their debt. Recently, the price of
aluminum increased by 30% and Delta feared a further increase. This raised the question of a
financial hedge on aluminum.

Problem Statement
The problem at hand here is that whether Delta Beverage Group should do a financial hedge on
aluminum or not to protect themselves from a potential price hike.

Alternatives for the problem:

The company has two choices, to either use futures to hedge its exposure from rising aluminum
prices or to take the risk and carry on like it has been.
We'll start by calculating some main financial ratios and assessing Delta's current financial
situation and try to explain them. Finally, we will project the firm's future along a variety of
possibilities in order to reach a conclusion and offer Mr. Bierbaum advice.

Financial Situation:
From the sales figures, we see that Delta Beverage Group is a large company showing moderate
growth. This growth is mostly enabled by the acquisitions that the firm has made in recent
years. In addition to that, the soft drink beverages industry as a whole is clearly showing signs
of diminishing growth. Since the company is also highly leveraged, we can conclude that Delta
Beverage Group is in the mature phase of the product life cycle. This will help us get better
insight on the company’s well-being while assessing the various financial ratios.
 D/E Ratio and Debt Ratio
1989 1990 1991 1992 1993
Debt 165.75 162.31 164.26 172.18 141.15
Equity 69.70 57.05 35.47 7.37 94.27
Total Assets 223.33 210.07 203.99 210.44 213.7
D/E Ratio 2.38 2.84 4.63 23.36 1.50
Debt Ratio 0.74 0.77 0.81 0.81 0.66

We can see from the D/E-ratio that the company was moderately leveraged during 1989-1991
with a peak in 1992 having a D/E ratio of 23.36. This peak was the point at which the
accumulated deficit reached its highest value and the year before the Recapitalization Plan was
performed. The ratio therefore in 1993 is much healthier at 1.50, according to firm
characteristics
The debt ratio indicates how much of the company's assets are financed by debt. Even after
recapitalization, the ratio continues to be disproportionate in this situation. As the likelihood of
default rises, so does the risk to the company. Investors will be less interested in Delta Beverage
Group as a result of this. Furthermore, because of the higher financial risk, borrowing additional
funds is almost impossible.

Return on Equity
1989 1990 1991 1992 1993
Net Income (18.866) (17.432) (14.835) (14.015) (7.877)
Equity 61.381 55.056 44.267 30.382 162.042
ROE -31% -32% -34% -46% -5%

From 1989 to 1993, DBG lost money on the bottom line, but this improved over the same time
span. The recapitalization was the most significant increase in net income; the debt for equity
swap resulted in lower interest expenses.
In addition, the rise in net income and equity demonstrates a significant increase in return on
equity. When net income improves, however, the large amount of equity yields a low return on
investment (ROI).
Current Ratio & Quick Ratio
1989 1990 1991 1992 1993
Current Assets 39.254 33.196 36.204 41.349 50.192
Inventory 8.893 6.726 9.808 10.607 10.104
Current Liabilities 27.733 19.233 21.998 27.291 18.147
Current Ratio 1,73 1,73 1,65 1,52 2,77
Quick Ratio 1,34 1,38 1,20 1,13 2,21
From a short-term perspective, we must consider two ratios in particular. Current Ratio and
Quick Ratio both of which help determine the liquidity position of the firm.
The current ratio measures the company's ability to meet its short-term obligations. It shows
how a company can maximize the current assets to fulfill its current debt and payables. The
quick ratio indicates the company's short-term liquidity position and measures its ability to
satisfy its short-term obligations with its liquid assets.
The current and quick ratio, it is important for a firm to have a ratio of above 1. Both remain
throughout the whole period above 1, so do not seem to pose a threat to the firm.
For a good current and quick ratio, it is imperative that they remain above 1. Here throughout
the period, they are well above 1 and hence Delta Beverages must not worry about this.
We'll now look at the idea of using hedging to shield the company from rising costs.

Hedging:
Bierbaum is considering a financial hedge because an operational hedge is not an option
because the output mix is related to the market segmentation strategy. Since there are no
future contracts available for fructose, concentrate, and other raw materials, they are not ideal
for a financial hedge. For the rest of the year, Bierbaum expects aluminum prices to remain
unchanged from 1993. For the rest of 1994, Bierbaum predicts that aluminum prices would
remain unchanged from 1993. While considering both the long and short-term fluctuations of
aluminum prices, Bierbaum's prediction appears to be very risky. Furthermore, aluminum's
annual price variance was 30.4 percent.
When contemplating a financial hedge on aluminum prices, Delta's exposure to aluminum
prices must be calculated, as well as the possibility of a violation of one of the debt facility
covenants. The interest coverage ratio, which must not fall below 2.0, is the most relevant
covenant.

Coverage Ratio
Aluminum Price 1993 1994 1995 1996
22.50% 2.12x 2.23x 2.04x 1.77x
20% 2.12x 2.23x 2.14x 2.00x
10% 2.12x 2.23x 2.55x 2.93x
Future 15M @ 22.5% 2.12x 2.23x 2.70x 2.79x
Future 27M @ 22.5% 2.12x 2.23x 2.60x 3.44x

Several conclusions can be made already:

  Purchasing aluminium in cash and assuming constant costs is 7-8 percent more
expensive than buying aluminium in a 15 or 27-month aluminium future. We will advise
Bierbaum to buy the futures if his interest coverage ratio is close to the appropriate
amount of 2.0, ignoring macroeconomics (e.g. rivals, market equilibrium). The main
argument for this conclusion is aluminum's 30 percent price volatility. Furthermore, DBG
is unable to adjust its product mix, and it is clear that overall aluminium costs account
for more than 10% of total sales costs (roughly 40 percent of the cost of aluminium cans
is the price of aluminum, and the sales of cans which accounts for 60 percent of the net
Revenue).
 A thorough understanding of the aluminium market is important. The LME is a
sophisticated trading site with a wide number of over-the-counter (OTC) items. It is
important to provide a thorough understanding of aluminum's usual price level. Buying
futures when there is a reasonable risk of long-term price declines can be disastrous on
a macroeconomic basis. The European airline industry, for example, is a clear example
of how most airlines bought futures to hedge their risk on oil prices. Ryanair was one of
the few airlines that had not purchased futures, which turned out to be one of the most
important competitive advantages. DBG must conduct a rigorous analysis of its
competitors' hedging strategies.
 The difference in price between a 15 and a 27-month future is small. If the possibility of
lower aluminium prices is not considered, we recommend purchasing the 27-month
future rather than the 15-month future.

First and foremost, we've assumed annual price increases of 22.5 percent, 20%, and 10%. Based
on the annual growth rate from July 1993 to June 1994, the rise is 22.5 percent. The increases
of 20% and 10% are fictitious figures used to construct various scenarios. We measured the
effect of various aluminium price rises on the interest coverage ratio and compared it to what
would happen if futures were purchased.
We may deduce that an increase in price has a significant impact on the coverage ratio. The
coverage ratio would fall below the covenant ratio of 2.0 in 1996 if the price increases by 22.5
percent. Bierbaum would have to buy futures in this case to protect himself from price
fluctuations. If the price rises by less than 20%, the covenant ratio would not fall below 2.0.
However, as seen in the table, buying futures would be more advantageous if the price rises. If
Bierbaum buys the 27-month futures, he must consider an 8.7% one-time price rise. This results
in an annual rise of around 3%.

Conclusion
Mr. Bierbaum is faced with a difficult decision: how to determine the danger of increasing
aluminium prices. We addressed the company's current financial position and concluded that,
despite losses, the company is on the right track. While the risk of default has decreased, the
prospect of issuing more debt remains slim. If prices rise, it will inevitably have negative
consequences.
The proposed strategy for protecting the business from increasing aluminium costs is hedging.
We discovered that the interest coverage ratio would not fall below 2.0 before 1996, according
to our calculations (assuming an aluminium price increase of 22.5 percent ). As a result, the
need to buy futures ahead of time has little to do with the interest coverage ratio. Hedging
effectively improves potential profitability if costs rise by at least 3%, according to our estimates
through various scenarios. Furthermore, Bierbaum must keep in mind that the aluminium
market is extremely volatile, and that unexpected increases in costs may jeopardise DBG's life.
As a result, we recommend that he hedge his risks by purchasing aluminium futures.