Argon Mining plc is investigating the possibility of purchasing an open-cast coal mine in South Wales at a cost of £2.5 million which the British government is selling as part of its privatisation programme. The company’s surveyors have spent the last three months examining the potential of the mine and have incurred costs to date of £0.2 million. The surveyors have prepared a report which states that the company will require equipment and vehicles costing £12.5 million in order to operate the mine and that these assets can be sold for £2.5 million in four years’ time when the coal reserves of the mine are exhausted.

The assistant to the Chief Financial Officer of the company has prepared the following projected profit and loss accounts (income statements) for each year of the life of the mine.

Projected Income Statements (Profit and Loss Accounts) (£m)

Year 1 2 3 4 Sales less Wages and salaries Selling and distribution costs Materials and consumables Depreciation and equipment Head office expenses Survey costs Interest charges Net profit (loss)

9.4

(2.3)

(1.3)

(0.3)

(2.5)

(0.6)

(0.4)

(1.2)

0.8 9.8

(2.5)

(1.2)

(0.4)

(2.5)

(0.6)

(1.2)

1.4 8.5

(2.6)

(1.5)

(0.4)

(2.5)

(0.6)

(1.2)

(0.3)

6.3

(1.8)

(0.6)

(0.2)

(2.5)

(0.6)

(1.2)

(0.6)

In his report to the Chief Financial Officer, the assistant recommends that the company should not proceed with the acquisition of the mine as the profitability of the proposal is poor.

The following additional information is available:

(i) The project will require an investment of £0.5 million of working capital from the beginning of the project until the end of the useful life of the mine.

(ii) The wages and salaries expenses include £0.5 million of working capital in Year 1 for staff who are already employed by the company but who would be without productive work until Year 2 if the project does not proceed. However, the company has no intention of dismissing these staff. After Year 1, these staff will be employed on another project with the company.

(iii) One-third of the head office expenses consists of amounts directly incurred in managing the new project and two-thirds represents an apportionment of other head office expenses to the project to ensure that it bears a fair share of these expenses.

(iv) The survey costs include those costs already incurred to date, and which are to be written off in the first year of the project, as well as costs to be incurred in the first year if the project is accepted.

(v) The interest charges relate to finance required to purchase the equipment and vehicles necessary to carry out the project.

(vi) After the mine has been exhausted, the company will be required to clean up the site and to make good the damage to the environment resulting from its mining operations. The company will incur costs of £0.4 million in Year 5 in order to do this.

The company has a cost of capital of 12 per cent.

Ignore taxation.

Required

(a) Using what you consider to be the most appropriate investment appraisal method, prepare calculations which will help the company to decide whether or not to proceed with the project.

(b) State, giving reasons, whether you think the project should go ahead.

(c) Explain why you consider the investment appraisal method selected in

(a) above to be most appropriate for evaluating investment projects.