Frank Hart, Sparkling Enterprises' controller, has gathered the following data to analyze an investment in new mining equipment which will allow the company to extract gold ore from once inaccessible sections of the Mountain Creek Mining Facility.
Acquiring and installing the equipment will involve an investment of $3,600,000. The useful life of the specialized equipment is estimated to be five years with no residual value at the end of this period. Sparkling uses the straight-line amortization method for this equipment for financial reporting purposes.
Using the equipment, Sparkling estimates that an additional 400 troy pounds of gold (12 troy ounces per pound) will be extracted annually for the next five years. Hart plans to use an estimated market price of $490 per troy ounce of gold in his analysis based on expert information. A significant risk factor is represented by the price of gold projected due to the numerous factors that could influence the value per troy ounce.
Variable costs to extract, sort, and pack the gold are $175 per troy ounce. Allocated fixed overhead costs are $48 per ounce.
Three skilled technicians will be hired to operate the new equipment. The total salary and fringe benefit costs for these three employees will be $198,000 annually over the next five years. Periodic maintenance on the equipment is expected to cost $85,000 per annum.
Sparkling requires a 12% after-tax required rate of return and is subject to a 40% tax rate. The equipment qualifies for a 30% declining balance capital cost allowance rate.
REQUIRED
1. Determine the payback period.
2. Calculate the after-tax net present value for Sparkling's proposed acquisition of the extraction equipment.
3. Determine the revenue per ounce of gold at which Sparkling's acquisition of the extraction equipment will break even from a net present value perspective where Sparkling earns the 12% after-tax required rate of return.
4. Hart feels that inflation will occur and persist for the next five years at the rate of 2% per year. Assume all the data given in the problem are already in nominal dollars and that the 12% minimum desired rate of return already includes an element attributable to anticipated inflation. Repeat requirement 2, to take inflationary effects into consideration.