Comparison of Hedging Approach with Conservative Approach

A comparison of the approaches can be made on the basis of (i) cost considerations, and (ii) risk considerations.

Cost Considerations

The cost of these financing plans has a bearing on the profitability enterprise. We assume that the cost of short term funds and long term funds, as in the Section dealing with profitability risk trade off, is 3 per cent and 8 per cent respectively.

Hedging Plan

The cost of financing under the hedging plan can be estimated as follow:

(I) Cost of short term funds. The cost of short term funds = average annual short term interest rate.
Average annual short term loan = total of monthly seasonal requirements (Col 4) by the number of months.
Average annual short term loan = Rs 11.600 + 12 = Rs 966.67.
Short term cost = Rs 966.67 x 0.03 = Rs 29.

(II) Cost of long-term funds = (Average annual long-term fund requirement) x (annual interest rate)

= Rs 6,900 x 0.08 = Rs 552.

(III) Total cost under hedging plan = total of (i) + (ii) = Rs 29 + Rs 552 = Rs 581

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