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.

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. For example, NWC at time zero

will equal 5% of total year-one revenue.

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. 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 $6 million. Assume that a loss

in any year will result in a tax credit applied against other income in that year.

Bethesda faces a 38 percent tax rate and has a 12 percent required return on new strip mine

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

the project.

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QUESTION: We now need to consider the depreciation of the equipment associated with the project. Why is this important even though depreciation is not a cash expense for the company?

Summary of Case Facts Equipment Land cost Aftertax land value Equipment Salvage Contract sales/tons Year 1 production Year 2 production Year 3 production Year 4 production Contract $/ton Spot market $/ton Variable cost/ton Year 1 depreciation Year 2 depreciation Year 3 depreciation Year 4 depreciation Fixed costs Reclamation costs Charitable expense NWC percent Tax rate Required return $85,000,000 $5,000,000 $5,500,000 60% 500,000 620,000 680,000 730,000 590,000 $82 $76 $31 14.29% 24.49% 17.49% 12.49% $4,100,000 $2,700,000 $6,000,000 5% 38% 12%