Black Mountain Mining is a midsized coal mining company with 20 mines located in
ID: 2726359 • Letter: B
Question
Black Mountain Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is sold under contract, with excess production sold on the spot market.
The coal mining industry, especially high-sulfur coal operations such as Black Mountain, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Black Mountain has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Black Mountain Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company feels it could receive $7 million on an after-tax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. Because it is currently operating at full capacity, Black Mountain will need to purchase additional necessary equipment, which will cost $85 million. The equipment will be fully depreciated on a straight line basis over 5 years. The contract runs for only four years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price in four years. However, Black Mountain plans to open another strip mine at that time and will use the equipment at the new mine.
The contract calls for the delivery of 500,000 tons of coal per year at a price of $85 per ton. Black Mountain Mining feels that coal production will be 620,000 tons, 680,000 tons, 730,000 tons, and 590,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $90 per ton. Variable costs amount to $31 per ton, and fixed costs are $4,300,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales.
Black Mountain will be responsible for reclaiming the land at termination of the mining. This will occur in year 5. The company uses an outside company for reclamation of all the company’s strip mines. It is estimated the cost of reclamation will be $2.8 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area. This will occur in year 6 and result in a charitable expense deduction of $7.5 million. Black Mountain faces a 38 percent tax rate and has an after tax weighted average cost of capital (WACC) of 12 percent on new strip mine projects. Assume that a loss in any year will result in a tax credit. Also assume that all cash flows occur at the end of each year.
You have been approached by the president of the company with a request to analyse the project. Calculate the payback period, profitability index, net present value and internal rate of return for the new strip mine. Should Black Mountain Mining take the contract and open the mine?
Explanation / Answer
Bethesda Mining Company
.
Since net working capital is built up ahead of sales, the initial cash flow depends in part on this cash outflow. So, we will begin by calculating sales. Each year, the company will sell 600,000 tons under contract, and the rest on the spot market. The total sales revenue is the price per ton under contract times 600,000 tons, plus the spot market sales times the spot market price. The sales per year will be:
Year
1
2
3
4
Contract
20,400,000
$20,400,000
$20,400,000
$20,400,000
Spot
$2,000,000
$5,000,000
$8,400,000
$5,600,000
Total
$22,400,000
$25,400,000
$28,800,000
$26,000,000
The current after-tax value of the land is an opportunity cost. The initial outlay for net working capital is the percentage required net working capital times Year 1 sales, or:
Initial net working capital = .05($22,400,000) = $1,120,000
So, the cash flow today is:
Equipment –$30,000,000
Land –5,000,000
NWC –1,120,000
Total –$36,120,000
Now we can calculate the OCF each year. The OCF is:
Year
1
2
3
4
5
6
Annual
Revenue
$22,400,000
$25,400,000
$28,800,000
$26,000,000
Less: Variable
Costs
$8,450,000
$9,425,000
$10,530,000
$9,620,000
Less: Fixed
Costs
$2,500,000
$2,500,000
$2,500,000
$2,500,000
$4,000,000
$6,000,000
Less: Depreciation
$4,290,000
$7,350,000
$5,250,000
$3,750,000
EBIT
$7,160,000
$6,125,000
$10,520,000
$10,130,000
($4,000,000)
($6,000,000)
Tax @ 34%
$2,434,400
$2,082,500
$3,576,800
$3,444,200
($1,360,000)
($2,040,000)
Net Income
$4,725,600
$4,042,500
$6,943,200
$6,685,800
($2,640,000)
($3,960,000)
Add: Depreciation
$4,290,000
$7,350,000
$5,250,000
$3,750,000
OCF
$9,015,600
$11,392,500
$12,193,200
$10,435,800
($2,640,000)
($3,960,000)
Years 5 and 6 are of particular interest. Year 5 has an expense of $4 million to reclaim the land, and
it is the only expense for the year. Taxes that year are a credit, an assumption given in the case. In
Year 6, the charitable donation of the land is an expense, again resulting in a tax credit. The land
does have an opportunity cost, but no information on the after-tax salvage value of the land is
provided. The implicit assumption in this calculation is that the after-tax salvage value of the land in
Year 6 is equal to the $6 million charitable expense.
Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of next
year’s sales, so the NWC requirement each year is:
Year
0
1
2
3
4
5
6
Beginning WC
$1,120,000
$1,270,000
$1,440,000
$1,300,000
Ending WC
$1,270,000
$1,440,000
$1,300,000
$0
NWC CF
($150,000)
($170,000)
$140,000
$1,300,000
The last cash flow we need to account for is the salvage value. The fact that the company is keeping
the equipment for another project is irrelevant. The after-tax salvage value of the equipment should
be used as the cost of equipment for the new project. In other words, the equipment could be sold
after this project. Keeping the equipment is an opportunity cost associated with that project. The
book value of the equipment is the original cost, minus the accumulated depreciation, or:
Book value of equipment = $30,000,000 – 4,290,000 – 7,350000 – 5,2502,000 – 3,750,000
Book value of equipment = $9,360,000
Since the market value of the equipment is $18 million, the equipment is sold at a gain to book
value, so the sale will incur the taxes of:
Taxes on sale of equipment = ($18,000,000 – 9,360,000)(.34) = $2,937,600
And the after-tax salvage value of the equipment is:
After-tax salvage value = $18,000,000 – 2,937,600
After-tax salvage value = $15,062,400
So, the net cash flows each year, including the operating cash flow, net working capital, and after-tax
salvage value, are:
Year
0
1
2
3
4
5
6
Capital
Spending
($30,000,000)
$0
$0
$0
$15,062,400
$0
$0
Opportunity
Cost
($5,000,000)
NWC
($1,120,000)
($150,000)
($170,000)
$140,000
$1,300,000
OCF
$9,015,600
$11,392,500
$12,193,200
$10,435,800
($2,640,000)
($3,960,000)
Total Project
Cash Flow
($36,120,000)
$8,865,600
$11,222,500
$12,333,200
$26,798,200
($2,640,000)
($3,960,000)
So, the capital budgeting analysis for the project is:
Payback period = 3 + $3,698,700/$26,798,200
Payback period = 3.14 years
Profitability index = p.v of future cash flows / initial capital layout = $39,167,225 /$ 36,120,000
Profitability index = 1.08
The equation for IRR is:
I have calculated the IRR using Trial & Error as noted on the attached excel sheet, the IRR = 15.6%.
MIRR = 13.39%
Year
0
1
2
3
4
5
6
OCF
($36,120,000)
$8,865,600
$11,222,500
$12,333,200
$26,798,200
($2,640,000)
($3,960,000)
PV Factor
@ 12%
1
0.8929
0.7972
0.7118
0.6355
0.5674
0.5066
PV
($36,120,000)
$7,915,714
$8,946,508
$8,778,528
$17,030,741
($1,498,007)
($2,006,259)
NPV
$3,047,225
From the above, the project should be undertaken since it has a positive Net Present Value, an IRR and MIRR that are higher than the required rate of return, a payback period that is less than 4 years, and finally a Profitability Index that is higher than 1.
Year
1
2
3
4
Contract
20,400,000
$20,400,000
$20,400,000
$20,400,000
Spot
$2,000,000
$5,000,000
$8,400,000
$5,600,000
Total
$22,400,000
$25,400,000
$28,800,000
$26,000,000
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