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
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.
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.