Bethesda Mining is a mid-sized coal mining company with 20 mines located in England and Scotland. 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-sulphur coal operations such as Bethesda, has been hit hard 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-sulphur coal. Bethesda has just been approached by Scottish Power with a request to supply coal for its electric generators for the next 4 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 Auchtermuchty on 5,000 acres of land purchased 10 years ago for £6 million. Based on a recent appraisal, the company feels it could receive £5 million on an after-tax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the 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 using capital allowances (reducing balance) at 20 per cent per annum. The contract runs for only 4 years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 per cent 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 600,000 tons of coal per year at a price of £34 per ton. Bethesda Mining feels that coal production will be 650,000 tons, 725,000 tons, 810,000 tons and 740,000 tons, respectively, over the next 4 years. The excess production will be sold in the spot market at an average of £40 per ton. Variable costs amount to £13 per ton, and fixed costs are £2,500,000 per year. The mine will require a net working capital investment of 5 per cent of sales. The NWC will be built up in the year prior to the 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 £4 million. After the land is reclaimed, the company plans to donate the land to the National Trust for use as a public park and recreation area. This will occur in year 6 and result in a charitable expense deduction of £6 million. Bethesda faces a 28 per cent tax rate and has a 12 per cent 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 chairman of the company with a request to analyse the project. Calculate the payback period, profitability index, average accounting return, net present value, internal rate of return, and modified internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?