Alexandria Mining is a midsized coal mining company with 20 mines in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most mined coal is sold under contract, with excess production sold on the spot market.

The coal mining industry, especially high-sulfur coal operations such as Alexandria, has been hard-hit by environmental regulations. However, increased demand for coal and new pollution-reduction technologies has recently improved market demand for high-sulfur coal. Mid-Ohio Electric Company has just approached Alexandria to supply coal for its electric generators for the next four years. Alexandria Mining needs more excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company could receive $7 million after tax 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 remove the coal and leave the land unusable. Changes in mining regulations force a company to reclaim the land; when the mining is completed, the land must be restored to its original condition. The land can then be used for other purposes. Because it is currently operating at full capacity, Alexandria will need to purchase additional necessary equipment, which will cost $8.5 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract runs for only four years; at that time, the coal from the site will be entirely mined. The company feels the equipment can be sold for 60 percent of its initial purchase price in four years. However, Alexandria plans to open another strip mine at that time and will use the equipment at the new mine.

The contract calls for delivering 500,000 tons of coal per year at a price of $95 per ton. Alexandria Mining feels that coal production will be 620,000 tons. 680,000 tons, 730,000 tons, and 590,000 tons, respectively, over the next four years. The excess production will be sold at an average of $90 per ton in the spot market. Variable costs are $31 per ton, and fixed costs are $4,300,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year before the sales.

Alexandria will be responsible for reclaiming the land at the termination of the mining. This will occur in year 5. The company uses an outside company to reclamation all company strip mines. It is estimated that the cost of reclamation will be $2.8 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area. This will occur in year 6 and result in a charitable expense deduction of $7.5 million. Alexandria faces a 38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit.

In analyzing the project:

1. What is the first step in analyzing the project?
2. What makes Year 5 and Year 6 so interesting? How important is the donation of the land?
3. Is the NPV of the project positive?
4. Should Alexandria Mining take the contract and open the mine? Why?