Question

Coppo is a copper mining firm. The output one year later is expected to be 1,000,000 lb Coppo has just purchased a new equipment to facilitate the copper mining. The mining machine costs Coppo $520,000. One year later, the machine will become obsolete and will be sold out as rubbish for only $20,000. Coppo has made some new hires to mine coppers. The cost of human capital is $0.40/ lb. The tax rate is 30% for Coppo. The 1-year continuously compounded interest rate is 6%. 1-year forward price is $1.00/lb, 1-year option prices for copper are shown in the table below. All products allow for physical delivery of copper, so that Coppo's tax can be considered for the total profit after hedging. Call S0.0649 $0.0500 $0.0376 $0.0274 S0.0194 Strike Price (S/ lb 0.950 0.975 1.000 1.025 1.050 Put S0.0178 $0.0265 $0.0376 $0.0509 $0.0665 The CEO of Coppo wants to manage the risk of copper price. Suppose that you are a financial adviser in an investment bank. Please write a proposal for Coppo, illustrating the need and some possible ways to perform risk management. Make comprehensive comparisons among various choices to convince your client of your financial expertise. Note: You may want to make relevant assumptions on the timing of the cash flows (from equipment costs, employee salaries and others). Remember to consider tax payments when managing Coppo's profit.

Answer 1

		RISK MANAGEMENT STRATEGY 1
		SELL IN FORWARD @$1 per pound
		e^0.06=	1.061836547
	A	Revenue   in year1	$1,000,000
	B	Human capital cost in year1	($40,000)	($0.04*1 million)
	C	Depreciation of equipment in year1	($500,000)	(520000-20000)
	D=A+B+C	Profit before tax	$460,000
	E=0.3*D	Taxes(30%)	$138,000
	F=D-E	Net Operating Income	$322,000
	G	Add: Depreciation	$500,000
	H=F+G	Operating Cash flow in year1	$822,000
	I	Cash Flow from Salvage	$20,000
	J=H+I	Total Cash Flow in year 1	$842,000
	K=J/(e^0.06)	Present Value of total Cash Flow	$792,966
	L	Cash Flow in year0(Mining machine )	($520,000)
	NPV=K+L	Net Present value of cashflow	$272,966
		RISK MANAGEMENT STRATEGY 2
		BUY PUT OPTION Strike Price $1.050/lb
		Total Cost of Option=$0.0665*1millionin year0	($66,500)
		If Price after one year is less than $1.050/lb,the loss in spot market will be offset by gain in option
		e^0.06=	1.061836547
	A	Revenue   in year1	$1,050,000	(1.05*1million)
	B	Human capital cost in year1	($40,000)	($0.04*1 million)
	C	Depreciation of equipment in year1	($500,000)	(520000-20000)
	D=A+B+C+X	Profit before tax	$510,000
	E=0.3*D	Taxes(30%)	$153,000
	F=D-E	Net Operating Income	$357,000
	G	Add: Depreciation	$500,000
	H=F+G	Operating Cash flow in year1	$857,000
	I	Cash Flow from Salvage	$20,000
	J=H+I	Total Cash Flow in year 1	$877,000
	K=J/(e^0.06)	Present Value of total Cash Flow	$825,927
	L	Cash Flow in year0(Mining machine )	($520,000)
	M	Cost of option in year0	($66,500)
	NPV=K+L+M	Net Present value of cash RISK MANAGEMENT STRATEGY 3 BUY PUT OPTION Strike Price $1.025/lb Total Cost of Options$0.0509*1millionin year0 0.0509 50900 $50,900 If Price after one year is less than $1.025/lb,the loss in spot market will be offset by gain in option eng. 06 Revenue in vear1 Human capital cost in yearl Depreciation of equipment in yearl Profit before tax Taxes(30%) Net Operating Income Add: Depreciation Operating Cash flow in yearl Cash Flow from Salvage Total Cash Flow in year 1 1.061836547 $1,025,000 (1.025*1million) $40,000) ($0.04*1 million) ($500,000) $485,000 $145,500 $339,500 $500,000 $839,500 $20,000 $859,500 $809,447 $520,000 ($50,900 $238,547 520000-20000 D-A+B+C+X E:03"D F-D-E H-F+G KJ/(e0.06) Present Value of total Cash Flow Cash Flow in year0(Mining machine) ost of option in yearo NPV-K+MM Net Present value of cashflow RISK MANAGEMENT STRATEGY 4 BUY PUT OPTION Strike Price $1.000/1b Total Cost of Option $0.0509*1millionin yearo 0.0376 37600 ($37,600) If Price after one year is less than $1.000/lb,the loss in spot market will be offset by gain in option e0.06- Revenue in yearl Human capital cost in yearl Depreciation of equipment in yearl 1.061836547 $1,000,000 (1.000*1million) ($40,000($0.04*1 million) ($500,000 $460,000 $138,000 322,000 $500,000 $822,000 $20,000 $842,000 $792,966 $520,000 ($37,600) $235,366 520000-20000 DEA+B+CtX Profit before tax "D Taxes(30%) F=D-E Net Operating Income Add: Depreciation Operating Cash flow in year1 Cash Flow from Salvage Total Cash Flow in year 1 H=F+G KJ/(e0.06) Present Value of total Cash Flow Cash Flow in year0(Mining machine) ost of option in year0 Net Present value of cashflow NPV-K+L+M flow	$239,427
		BUYING In FORWARD WILL GIVE HIGHER NET PRESENT VALUE