Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio,

Pennsylvania, West Virginia, and Kentucky. 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-sulfur coal operations such as Bethesda,

has been hard-hit 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-sulfur coal. Bethesda has just been approached by

Mid-Ohio Electric Company with a request to supply coal for its electric generators for

the next four 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 Ohio on 5,000 acres of land purchased 10 years ago for $5 million. Based on a recent

appraisal, the company feels it could receive $5.5 million on an aftertax 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 $85 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 that the

equipment can be sold for 60 percent of its initial purchase price in four years. 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 500,000 tons of coal per year at a price of $82 per

ton. Bethesda 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 in the spot market at an average of $76 per ton. Variable costs amount to

$31 per ton, and fixed costs are $4,100,000 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 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 $2.7 million. In order

to get the necessary permits for the strip mine, the company agreed to donate the land after

reclamation 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 $6 million. Bethesda 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.

You have been approached by the president of the company with a request to analyze

the project. Calculate the payback period, profitability index, net present value, and internal

rate of return for the new strip mine. Should Bethesda Mining take the contract and

open the mine?