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 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 that costs $5 million 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 (see paragraph three below for further information regarding the land reclamation). Because it is currently operating at full capacity. Bethesda will need to purchase additional necessary equipment, which will cost $64 million. The equipment will be depreciated on a four-year straight-line 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 will be worthless at the end of the contract (i.c., a market salvage value of zero). The contract calls for the delivery of 500,000 tons of coal per year at a price of $80 per ton. Bethesda Mining feels that coal production will be 600,000 tons, 700,000 tons, 800,000 tons, and 500,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $70 per ton. Variable costs amount to S30 per ton, and fixed costs are $4,000,000 per year. The mine will require a networking capital (NWC) investment of 5 percent of sales. The NWC will be built up in the year prior to the sales (1.c., 5% of next year sales) Bethesda 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 for the reclamation of all the company's strip mines. It is estimated the cost of reclamation will be $2.5 million. Bethesda faces a 28 percent tax rate and has a 12.5 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 net present value and internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine? Notes for solution: 1. Land purchase Assume that the land has no value at the end of the project. Also, land cannot be depreciated based on IRS rules. So do not assign depreciation to the land. 2. Project termination in year 5: This is relevant although the production ends at the end of year 4. Remember to take into account year-5 reclamation cost (although there are no sales or other expenses in year 5). Assume that the firm is profitable and can use this expense to reduce the tax payment 3. Net working capital calculation: Net working capital is 5% of next year's sales. That means that in year 4, NWC is closed since there are zero sales in year 5. 4. Points allocation: a. Sales 20 points b. Costs 30 points c. Cash flow adjustments 30 points d. NPV and IRR 20 points
