You are just hired by M Mining as the company's financial officer.Dave, the sole owner of the
Question:
You are just hired by M Mining as the company's financial officer.Dave, the sole owner of the all-equity-financed private company, is evaluating two mutually exclusive projects.
M has just been approached by a jeweler with a request to supply gold for its products for next six years. The company does not have enough excess capacity at its existing mines to guarantee the contract.It is considering opening a new gold mine in China. Betty , the company's geologist, has just finished her analysis of the mine site. She has estimated that the mine would be productive for six years, after which the gold would be completely mined. You have used the estimates provided by Betty and the agreed quantities and prices with the jeweler to determine the revenues that could be expected from the mine. You have also projected the expense of opening the mine and the annual operating expenses. If the company opens the mine, it will cost $80 million today, and it will have a cash outflow of $20 million seven years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in Table 1.
On the other hand, M owns 5,000 acres of land with a high-sulfur coal vein (also in China) purchased five years ago for $6 million.The firm has been planning to open this mine, but so far there were other more attractive projects. Based on a recent appraisal, the company feels it could receive $10 million on an after-tax basis if it sold the land today.The coal mining industry 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 for high-sulfur coal. So M thinks that the timing of opening the coal mine now is perfect.
The company is considering opening the coal mine with all production to be sold in the spot market over the next five years. At that time the coal from the site will be entirely mined. Additional necessary equipment will cost $85 million today and can be used only for this project. M will be responsible for reclaiming the land at termination of the coal mining.This will occur in year 6. The expected (incomplete) cash flows of the coal mine are shown in Table 1.
M can proceed with only one of the projects without raising new capital. Dave, who is not very knowledgeable about finance concepts, has never used discount rate to do project evaluation, though he understands the concepts of time value of money. He has heard from friends about internal rate of return (IRR) being a single number summarizing the return of a project and would like to use this measure to help make the decision.
Evaluate the two projects and suggest which mine(s) to open now. It is also your responsibility to suggest appropriate financial policies for the firm.
Table 1 | |||
Year | Expected Cash Flows of Gold Mine | Expected Cash Flows of Coal Mine | |
0 | (80,000,000) | ? | |
1 | 16,000,000 | 26,000,000 | |
2 | 18,000,000 | 31,500,000 | |
3 | 28,000,000 | 32,000,000 | |
4 | 36,000,000 | 35,000,000 | |
5 | 39,000,000 | 36,000,000 | |
6 | 25,000,000 | (3,000,000) | |
7 | (20,000,000) |
Corporate Finance A Practical Approach
ISBN: 9781118217290
2nd Edition
Authors: Michelle R Clayman, Martin S Fridson, George H Troughton, Matthew Scanlan