1. Ace Mining Company is planning to take a lease on atract of landing in minera

Question

1.

Ace Mining Company is planning to take a lease on atract of landing in mineral rich Congo. The lease is in an area where government control is weak and civil disturbances may not allow full potential of exploiting the copper ore in the area. The initial investment in the lease and mine is $150million. The best estimates are that the net cash flow from the mining operation will be $20 million at the end of each year for the next 15 years. The cost of capital for Ace is 12%.

i. Should Ace take the lease?

ii. Ace's best guess is that the cash flow will be $20 million a year, but if the civil confict the area intensifies, the cash flow may be $10million a year but if the government is successful in establishing its authority, it may be $30million. It will take two years before the political situation resolves and the company will know if the cash flow will be $10 million (50% chance) or $25million (50% chance). If the company wait two years to apply for lease the investment will increase to $170 million. The cash flow period will still be 15years. Use decision tree analysis to determine if it makes sense to wait 2 years.

2.Rework problem 1 using the Black-Scholes model to estimate the value of the option. Assume that the variance of the project's rate of return is 8.48% and the risk-free rate is 7%.

Explanation / Answer

1. Initial investment = 150$million.

Cash flow= 20$million

N= 15 years.

COC= 12%

Present Value of cash flows= 136.22$ million

NPV= 136.22- 150= -13.78$

The company should not take the lease.

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