8%. INVESTMENT DECISIONS UNDER UNCERTAINTY Peru Resources Maxine Peru, the CEO of Peru Resources was absorbed by the report handed to her as she entered the executive dining room. The report described a proposed new mine on the North Ridge of Mt.Zircon.A vein of transcendental zirconium (TZ) ore has been discovered there on land owned by Mrs.Peru's company. Test borings indicated sufficient reserves to produce 340 tons per year of TZ over a 7 year period. The vein probably also contained hydrated zircon gemstones. The amount and quality of these zircons were hard to predict, since they tended to occur in "pockets". The new mine might come across one two or dozens of pockets. The mining engineer guessed that 150 pounds per year might be found. The current price for higher quality hydrated zircon gemstones was $3,300 per pound Peru resources was a family-owned business with total assets of $45 million. The outlay required for the new mine would be a major commitment. Fortunately, Peru Resources was conservatively financed and Mrs.Peru believed that the company could borrow up to $9 million at an interest rate of The mine's operating costs were projected at $900,000 per year, including $400,000 of fixed costs and $500,000 of variable costs. Mrs.Peru thought these forecasts were accurate. The big question marks seemed to be the initial cost of the mine and the selling price of TZ. Opening the mine and providing the necessary machinery and ore-crunching facilities,was supposed to cost $10 million, but cost overruns of 15% was common in the mining business. In addition,new environmental regulations, if enacted.could increase the cost of the mine by $1.5 million There was a cheaper design for the mine which would reduce its cost by $1.7 million and eliminate much of the uncertainty about cost overruns. Unfortunately, this design would require much higher fixed operating costs Fixed costs would increase to $850,000 per year at planned production levels. The current price of transcendental zirconium was $10,000 per ton but there was no consensus on the future prices. Some optimistic experts were projecting rapid price increases to as much as $14.000 per ton in addition to an initial investment drop of 20% and no environmental costs. On the other hand, there were pessimists saying that prices could be as low as $7,500 per ton. Mrs.Peru did not have strong views either way Her best guess was that price would just increase with inflation at about 3.5 % per year.{Mine operating costs would also increase with inflation) Mrs.Peru had wide experience in the mining business and she knew that investors in similar projects usually wanted a forecast nominal rate of return of at least 14% Tax rate is 35% and straight line depreciation is used. 2. Calculate NPV of the investment for the most likely case (base-case )using $10.000 as the initial cost and $10,000 as the price of TZ.Note that the company has a 35% tax rate. The investment is assumed to depreciate on a straight line basis over 7 years. Sales revenue stems from sale of TZ and zircon gemstones. Find the base-case NPV for the expensive design. Required: 1. What is the real rate of return that you can use to estimate NPV,assuming that real cash flows are used? 2. Calculate NPV of the investment for the most likely case (base-case )using $10,000 as the initial cost and $10,000 as the price of TZ.Note that the company has a 35% tax rate. The investment is assumed to depreciate on a straight line basis over 7 years. Sales revenue stems from sale of TZ and zircon gemstones. Find the base-case NPV for the expensive design. 3.Conduct a sensitivity analysis for TZ price and initial cost variables, for the base-case (expensive design) using the following assumptions: 3.a Pessimistic scenarios: 3.a.1.1.Initial cost: 15% cost overrun combined with environmental regulation costs of 1.5 million. 3.a1.1.2 25% drop in price b. Optimistic scenarios: 3.b.1 20% initial cost reduction (and no environmental regulation costs) 3.b.2. TZ Price =$14,000 4 Camnare vur results with the results of hace case of 8.What options does Mrs.Peru have for the investment decision