Suppose that a mining operation has spent $8 million developing an ore deposit i
ID: 2649867 • Letter: S
Question
Suppose that a mining operation has spent $8 million developing an ore deposit in South America. Current expectations are that the deposit will require 2 years of development and will result in a realizable cash flow of $10 million at that time. The company engineer has discovered a new way of extracting the ore in only 1 year, but the procedure would necessitate an immediate outlay of $1 million.
Required:
Compute the IRR for the new outlay. (Note: There are two solutions! One is 787%. Find the other one.)
Based on your answer to (a), use the IRR criterion to determine if the company should make the outlay. Assume the market interest rate is 15% on 1- and 2-year bonds.
Explanation / Answer
Answer
a) Compute the IRR for the new outlay
A mining operation has spent $8 million developing an ore deposit in South America.
Current expectations are that the deposit will require 2 years of development and It will result in a realizable cash flow of $10 million at that time. So there will be inflow of $ 10 million at end of year 2.
The company engineer has discovered a new way of extracting the ore in only 1 year, but the procedure would necessitate an immediate outlay of $1 million.
So the company will receive inflow of $ 10 million at the end of year 1 provided it spends immediately $1 million. So total outflow at initial year 0 will be $ 9 million (8+1)
Now, Internal rate of return is discount rate makes the net present value of all cash flows from a particular project equal to zero.
We have to find out IRR by trail and error method by assuming different discount rates.
Suppose discount rate is 11.11%
(Figures in millions)
year
Cash flow
Disc rate - 11.11%
Present value
A
B
A*B
0
-9
1
-9
1
10
0.90
9
IRR
11.11%
NPV
0
Answer : So IRR for new outlay is 11.11%
b)
Based on your answer to (a), use the IRR criterion to determine if the company should make the outlay. Assume the market interest rate is 15% on 1- and 2-year bonds.
If Company spends additional $ 1 million then IRR will be 11.11% as per answer (a)
If Company does not spend additional $ 1 million then IRR will be as per shown table below.
Suppose discount rate is 11.80%
(Figures in millions)
year
Cash flow
0
-8
1
0
2
10
IRR
11.80%
Answer : So IRR as per answer a) is 11.11% and without additional outlay is 11.80% (in 2 years time) which is lower than market interest rate of 15% on 1- and 2-year bonds.
So company should not make outlay.
year
Cash flow
Disc rate - 11.11%
Present value
A
B
A*B
0
-9
1
-9
1
10
0.90
9
IRR
11.11%
NPV
0
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