Hi, thank you for helping! Based on a Mini Case presented in the textbook Ross,

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Hi, thank you for helping!

Based on a Mini Case presented in the textbook Ross, S.A., R.W. Westerfield and J. Jaffe, Corporate Finance, McGraw Hill/Irwin. Bethesda 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 Bethesda, 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. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda 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 $5 million. Based on a recent appraisal, the company feels it could receive $4.7 million on an aftertax basis if it sold the land today. Strip mining is a process where the layers of topsoil above vein are removed and the exposed soil is removed. Some time ago, the company would simply remove the coil and leave the land in an unusable condition. Changes in the mining regulations now force the a company to reclaim the land; that is, when 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, Bethesda will need to purchase additional necessary equipment, which will cost $30 million. The equipment will be depreciated on a seven-year MACRS schedule. 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. However, Bethesda 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 $45 per ton. Bethesda Mining feels that call production will be 530,000 tons, 630,000 tons, 700,000 tons, and 630,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $50 per ton. Variable costs amount to $17 per ton, and fixed costs are $2,500,000 per year. The mine will require a net working capital investment of 3 percent of sales. The NWC will be built up in the year prior to sales. Bethesda 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 $3.5 million. After the land is reclaimed, the company plans to denote 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 $5 million. Bethesda faces a 40 percent tax rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit. You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index, net present value and internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?

Explanation / Answer

Computation of NPV:

Year

Cash flow

Discount factor@12%

Discounted flow

0

-26020000

1

-26020000

1

9208800

0.8928

8221617

2

11542800

0.7971

9200766

3

11983800

0.7117

8528870

4

13602800

0.6355

8644579

8,575,832

Thus, the NPV is 8,575,832.

Working notes:

On cash inflows:

Particulars

Year 1

Year 2

Year 3

Year 4

Total

Sales tons

530000

630000

700000

630000

2490000

Sale value

24000000

29000000

32500000

29000000

114500000

Less:

Variable costs @17

9010000

10710000

11900000

10710000

42330000

Fixed costs

2500000

2500000

2500000

2500000

10000000

Depreciation

4287000

7347000

5247000

3747000

20628000

Net income

8203000

8443000

12853000

12043000

41542000

Less:

Tax @40%

3281200

3377200

5141200

4817200

16616800

Income after tax

4921800

5065800

7711800

7225800

24925200

Add:

Depreciation

4287000

7347000

5247000

3747000

20628000

Cash flows

9208800

12412800

12958800

10972800

45553200

On cash outflows:

Particulars

Year 1

Year 2

Year 3

Year 4

Total

Purchase of equipment

-30000000

-30000000

Add:

Net working capital

-720000

-870000

-975000

-870000

-3435000

Less:

Sale of old equipment

4700000

4700000

Add:

Reclaimation

3500000

3500000

-26020000

-870000

-975000

2630000

-25235000

Year

Cash flow

Discount factor@12%

Discounted flow

0

-26020000

1

-26020000

1

9208800

0.8928

8221617

2

11542800

0.7971

9200766

3

11983800

0.7117

8528870

4

13602800

0.6355

8644579

8,575,832

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