A forecasted increase in metal prices has encouraged the Delta Resource Company
ID: 1199114 • Letter: A
Question
A forecasted increase in metal prices has encouraged the Delta Resource Company to consider the expansion of the capacity in one of its open pit mine operations in Northern Ontario. For this purpose, the following after tax cash flow estimates have been made.
Existing Capacity: Positive after tax annual cash flows of $12.5 million over the remaining 10-year mine life.
Expanded Capacity: $40 million capital expenditure now (time 0), followed by positive annual cash flows of $20 million over the remaining 8-year mine life.
a) Determine the distribution of after-tax cash flows, as well as the rate of return associated with the considered incremental investment for expanding the production capacity.
b) If the company's cost of capital is 30% and it is considering selling the mine, what should its minimum acceptable selling price be? What capacity option did you choose? Explain your answer.
Explanation / Answer
a.
Distribution of after-tax cash flows = Expanded cash flows – Existing cash flows
= $20,000,000 - $12,500,000
= $7,500,000
Calculation of rate of return:
Estimated life is 8 years.
Factor = Cost / After-tax cash flows = $40,000,000 / $7,500,000 = 5.3333
The nearest discount factors on the 8-year now in the table are 5.3349 and 5.1461 and the corresponding discount rates are 10% and 11% respectively.
Discount rate
Discount factor
After-tax cash flows
PV
10%
5.3349
7,500,000
40,011,750
11%
5.1461
7,500,000
38,595,750
Difference
1,416,000
Rate of return = 10% + {(40,011,750 – 40,000,000) / 1,416,000}
= 10% + 0.008
= 10.008%
Discount rate
Discount factor
After-tax cash flows
PV
10%
5.3349
7,500,000
40,011,750
11%
5.1461
7,500,000
38,595,750
Difference
1,416,000
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