MGMT 8605M Week 11 Final Risk Paper Example

Diesel Is the Exposure a Midwest Carrier Can Least Afford to Misjudge, and Its Tolerance Is Set Too Loosely: A Final Risk Paper Defending Cash Flow at Risk for a Firm With No Traded Portfolio, With Every Figure Traced to Its Source

Student Name

Walden University

MGMT 8605M: Financial Risk Management and Decision Making for Organizations

Instructor Name

Month Day, Year

Diesel Is the Exposure a Midwest Carrier Can Least Afford to Misjudge, and Its Tolerance Is Set Too Loosely: A Final Risk Paper Defending Cash Flow at Risk for a Firm With No Traded Portfolio, With Every Figure Traced to Its Source

Introduction

Calloway Freight, the composite Des Moines truckload carrier profiled earlier in this course, runs 210 tractors on Midwest lanes and burns about 3.5 million gallons of diesel a year. Its fiscal 2027 budget, approved in August 2026, assumes an average retail diesel price of $3.75 a gallon.

This paper argues two things. First, diesel cost is the exposure Calloway can least afford to misjudge, because it is large, volatile and only partly passed through to customers. Second, the company's current tolerance for unbudgeted fuel cost, which allows up to $3.0 million before the matter goes to the owners, is set too loosely, because a smaller overrun would already threaten the fixed-charge coverage covenant in its equipment loan agreement.

Literature, Arranged by Question

Why should a firm manage risk at all? Smith and Stulz (1985) argued that value-maximizing firms hedge because of taxes, the costs of financial distress and the effect of risk on investment decisions, which explains why some firms hedge and others do not. Froot et al. (1993) developed the investment argument: when outside finance is costly, risk management preserves internal funds for valuable investment. Stulz (1996) refined the purpose to avoiding costly lower-tail outcomes rather than eliminating variability.

How much do firms actually hedge? Guay and Kothari (2003) examined nonfinancial firms' derivative positions and found them small relative to the firms' overall exposures, suggesting that hedging programs often address only a fraction of risk. For Calloway, the fuel surcharge functions as a contractual hedge, and the question is how much it leaves uncovered.

How should exposure be measured? Jorion (2007) set out value at risk, the loss on a portfolio over a short horizon at a given confidence level. Stein et al. (2001) argued that for nonfinancial firms, whose risk shows up in operating cash flow rather than portfolio value, cash flow at risk is the more meaningful measure, and showed how to estimate it.

Which exposures can be measured at all? Knight (1921) distinguished risk, which can be quantified from experience, from uncertainty, which cannot. Earlier work in this course used that distinction to set a cyber outage apart from the measured exposures.

Method: Cash Flow at Risk Over Value at Risk

Value at risk is designed for traded portfolios marked to market daily. Calloway has no traded portfolio; its exposure appears as operating cost over a fiscal year. This paper therefore measures cash flow at risk: the shortfall in operating cash flow against budget, over the fiscal year, at a stated confidence level, arising from diesel price moves net of surcharge recovery.

The distribution of price moves comes from the weekly Midwest retail diesel series published by the federal energy statistics agency (U.S. Energy Information Administration, 2026). Over the ten years to October 2026, the 95th percentile of 52-week increases in that series was about $1.87 a gallon. The paper uses that historical distribution rather than a normal assumption because, as noted in the course's assumptions work, fuel price changes have heavier tails than a normal model implies.

Findings

The exposure, as defined in the course's inventory work, is about $88,000 of annual operating cost per ten-cent sustained move in the series, net of the 75 percent surcharge recovery.

Two findings follow. First, the budget is already wrong. The series stood at $6.29 on October 5, 2026, more than $2.50 above the $3.75 budget assumption. If prices held at that level all year, unrecovered fuel cost would exceed budget by about $2.2 million. Second, the risk around that already-adverse level is substantial: a further rise equal to the historical 95th percentile, $1.87, would add about $1.6 million, while a fall of the same historical 5th-percentile size, about $1.01, would recover about $0.9 million.

The revised scenario table from earlier coursework, updated with the October 2026 price, puts the base case at $2.2 million of unbudgeted cost, the adverse case at $3.8 million and a favorable case at $1.3 million.

Discussion: The Tolerance Is Too Loose

Under Calloway's equipment loan agreement, fixed-charge coverage may not fall below 1.25 at the annual test. Based on the fiscal 2026 audited statements, the company's coverage was 1.48, and the paper estimates that unbudgeted operating cost of about $2.0 million would bring it to the minimum. The current tolerance, $3.0 million before owner escalation, sits above that capacity. In the base case the covenant would be at risk before the tolerance triggered.

The paper proposes three changes, offered as the writer's recommendations rather than findings. Lower the owner escalation trigger to $1.2 million of projected unbudgeted fuel cost, about 60 percent of capacity. Rebase the fiscal 2027 fuel budget now, at the October price, so that the tolerance measures surprises rather than a known gap. And negotiate surcharge terms on the largest shipper contract, which comes up for rebid in March, to reduce the lag that drives most of the unrecovered share.

Limitations

The covenant estimate relies on one year's statements and assumes other costs hold to budget. The surcharge recovery rate of 75 percent is a historical average and could differ in a year of rapid price change.

Conclusion

Diesel is Calloway's largest measurable exposure, and the October 2026 price level has already moved it outside the budget. A tolerance set above covenant capacity offers no warning in time to act.

Appendix: Trace of Figures

[after]

Every figure in the paper can be checked against the document listed.

Table 1

Source for Every Figure in the Paper

References

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Guay, W., & Kothari, S. P. (2003). How much do firms hedge with derivatives? Journal of Financial Economics, 70(3), 423-461. https://doi.org/10.1016/S0304-405X(03)00179-X

Jorion, P. (2007). Value at risk: The new benchmark for managing financial risk (3rd ed.). McGraw-Hill.

Knight, F. H. (1921). Risk, uncertainty and profit. Houghton Mifflin.

Smith, C. W., & Stulz, R. M. (1985). The determinants of firms' hedging policies. Journal of Financial and Quantitative Analysis, 20(4), 391-405. https://doi.org/10.2307/2330757

Stein, J. C., Usher, S. E., LaGattuta, D., & Youngen, J. (2001). A comparables approach to measuring cashflow-at-risk for non-financial firms. Journal of Applied Corporate Finance, 13(4), 100-109. https://doi.org/10.1111/j.1745-6622.2001.tb00430.x

Stulz, R. M. (1996). Rethinking risk management. Journal of Applied Corporate Finance, 9(3), 8-25. https://doi.org/10.1111/j.1745-6622.1996.tb00295.x

U.S. Energy Information Administration. (2026). Midwest No. 2 diesel retail prices, weekly [Data set]. https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=EMD_EPD2D_PTE_R20_DPG&f=W