Hickock Mining is evaluating when to open a gold mine. The mine has 41,600 ounce
ID: 2782639 • Letter: H
Question
Hickock Mining is evaluating when to open a gold mine. The mine has 41,600 ounces of gold left that can be mined, and mining operations will produce 5,200 ounces per year. The required return on the gold mine as 12% and it will cost $33.2 million to open the mine. When the mine is opened, the company will sign a contract that will guarnatee the price of gold for the reamianing life of the mine. If the mine is opened today, each ounce of gold will generate an aftertax cash flow of $1,320 per ounce. If the company waits once year, there is a 60% probability that the contract price will generate an aftertax cash flow of $1,520 per ounce and 40% probability that the aftertax cash flow will be $1,220. What is the value of the option to wait. Please show your work.
Explanation / Answer
Number of years = 41600/5200 = 8
Annual cashflow = 1320*5200 = 6864000 = 6.864 million
NPV = -33.2 + PV of annual cashflows
PV of annual cashflows = 6.864*(1-(1+12%)-8) / 12% = 34.097879
NPV = -33.2+34.097879 = 0.897879
Now what if company waits for 1 year
Contract price = 0.6*1520 + 0.4*1220 = 1400
Annual cashflow = 1400*5200 = 7280000 = 7.28 million
NPV = -33.2 + PV of annual cashflows
PV of annual cashflows = 7.28*(1-(1+12%)-8) / 12% = 36.164418
NPV = -33.2+36.164418 = 2.964418
PV of next year NPV = 2.964418/1.12 = 2.646801 million
Value of th option = 2.646801 - 0.897879 = 1.748922 million
It is better to open the mine next year
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