Explain the alternative risk management approaches

Assignment Help Financial Management
Reference no: EM13199544

Today is February 1. Henry, the financial manager of Mesa Mines Inc., is looking at the budget for next year. Mesa is a medium-sized mining company that develops and extracts gold ore, then forwards it to a major company that smelts Mesa's ore and stores the gold in return for royalties when the metal is sold. Last year, mine output grew at the rate of 9% and rising prices of gold resulted in a record profit. The company increased its inventory of gold at the senior company to 26,700 troy ounces, due to smelting difficulties that delayed sales. The average cost of this gold inventory is US$1,300 per ounce, and gold traded at about US$1,700 per ounce at year end. Since then, the price has dropped to about US$1,600 per ounce. Henry believes that Mesa needs a minimum price of US$1,500 per ounce to make a reasonable profit.

Although Henry is happy that his company has unrealized profit from its gold inventory, he is aware that the price of gold is very volatile. With a potential increase in interest rates, he is worried that sales will weaken and prices will drop.

Henry does not want to be forced to sell under downward market pressure. Mesa might not sell its gold Inventory before the price drops below US$1,500 per ounce, and could be left with a declining price, creating losses. Further complicating this issue is that gold Is priced In US$ and the company operates in C$.

Mesa sold gold futures on 14,500 ounces in August at a price of US$1,575 per ounce. The mine produces about 4,500 ounces of gold per month. Henry expects to be able to sell current production on a monthly basis, but the backlogged sales in inventory may take six months to clear.

Gold futures options are sold on the CME Group's Commodity Exchange (COMEX), where contracts are for 100 ounces.

a. 

i. How can Henry use options to hedge Mesa's gold revenues?

ii. Henry obtained the information shown in Exhibit A from his broker. If Henry hopes to gradually sell all of Mesa's current gold inventory plus projected production during the next six months, how many ounces should he consider hedging? Which of the following options should Henry buy or sell to make an effective, cost-efficient hedge?

Exhibit A: Gold futures option premiums

484_Gold futures option premiums.png

b. How many options should Henry buy to cover sales, and what is Mesa's total cost of premiums for the option contracts?

c. Assume Henry purchased June options to hedge part of his potential losses. However, at the end of April, Mesa has a purchaser for 12,000 ounces of gold at the market price, which is US$1,520 per ounce. Option prices are now as shown in Exhibit B. Suppose the total premium paid for the June contracts was US$35,000. Ignoring the time value of money, what is the effective price per ounce that Henry will receive for the April sale?

d. Comment on the effectiveness of the June hedge using the realized price at the end of April.

409_Gold futures option premiums1.png

e. Mesa's senior managers receive an annual bonus plan based on earnings before interest, taxes, and depreciation (EBITD). This bonus plan pays an increasing premium for performance higher above budget and nothing if performance is below budget. Mesa's new treasurer suggests to Henry that the firm should take an opportunistic approach to risk management and try to profit from the use of gold futures and options.

i. Explain the alternative risk management approaches and their advantages and disadvantages for a medium-sized gold producer such as Mesa. State which approach you think is appropriate for Mesa and why.

ii. Explain how Mesa's bonus plan based on EBITD could give an incentive for management to work harder for shareholders, and how it could cause agency or ethical issues.

Reference no: EM13199544

Questions Cloud

What is the kinetic energy of the ball : A bowling ball of mass 5.2 kg falls from a roof 7.8 m above the ground. When the ball reaches the ground, what is the kinetic energy of the ball?
State what time was it when looked at watch : At a certain time, Janice notices that her digital watch reads (a) minutes after two o'clock. Fifteen minutes later, it reads (b) minutes after three o'clock. She is amused to note that
Explain how equilibrium is restored in the economy : explain briefly what is happening in this economy before and beyond the equilibrium output level point "a". The equilibrium output is the level of output at which the 45-degree line intersects the planned expenditures line.
How much is surplus is lost when there is a monopoly : PC and QC are the equilibrium price and quantity if the firm behaves competitively, and PM and QM are the equilibrium price and quantity if the firm is a simple monopoly. how much is surplus is lost (deadweight loss) when there is a monopoly
Explain the alternative risk management approaches : Explain the alternative risk management approaches and their advantages and disadvantages for a medium-sized gold producer such as Mesa. State which approach you think is appropriate for Mesa and why.
Find the scale of the model : A Model boat has a length span of 20cm. The real length is 4cm. Find the scale of the model?
State what is room temperature in celsius and kelvin : What is room temperature in celsius and kelvin? How do you do that using Tf=1.8(Tc)+32 and Tk=Tc+273.
What is the area of the base of the box : a box has a heigght of 16 centimeters and a volume of 2304 cubic centimeters. what is the area of the base of the box?
Provide a definition by recursion of a function f : Provide a definition by recursion of a function F such that for every wff (well formed formula) A, F(A) is a wff (well formed formula) obtained from A by replacing all occurrences of p with q and all occurrences of q with p simultaneously. (For ex..

Reviews

Write a Review

Financial Management Questions & Answers

  Foreign company acquisition

Acquisition by a foreign company and the effects of that decision and the results of foreign exchange in Euro and the exchange rate differences.

  Financial management for profit and non profit organizations

In this essay, we are going to discuss the issues of financial management in a non-profit organisation.

  Method for estimating a venture''s value

Evaluate venture's present value, cash and surplus cash and basic venture capital.

  Replacement analysis

This document show the Replacement Analysis of modling machine. Is replacement give profit to company or not?

  Business finance task - capital budgeting

Your company is considering using the payback period for capital-budgeting. Discuss the advantages and disadvantages of this technique.

  Analysis of the investment

In this project, you will focus on one of these: the additional cost resulting from the purchase of an apple press (a piece of equipment required to manufacture apple juice).

  Conduct a what-if analysis

Review the readings and media for this unit, including the Anthony's Orchard case study media. Familiarise yourself with the Anthony's Orchard company and its current situation.

  Determine operational expenditures

Organisations' behaviour is guided by financial data. In the short term, such data will help determine operational expenditures; in the long term, historical data may help generate forecasts aimed at determining strategic plans. In both instances.

  Personal financial management

How much will you have left over each half year if you adopt the latter course of action?

  Sources of finance for expansion into new foreign markets

A quoted company is considering several long-term sources of finance for expansion into new foreign markets.

  Long term financial planning

This assignment is designed for analyze Long term financial planning begins with the sales forecast and the key input in the long term fincial planning.

  Explain the role of fincial manager

This assignment explain the role of fincial manager, function of manger. And what are the motives of financial manager.

Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd