Christie Fontaine, President of the Sherbrooke Mining Limited (SML) is going over the engineering report she received as soon as she came to the office in the morning. The report described a proposed new mine in Thunder Bay. A vein of transcendental zirconium ore had been discovered there on land owned by SML. Test borings indicated sufficient reserves to produce 340 tons per year of transcendental zirconium 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 high-quality hydrated zircon gemstones was $3,300 per pound. SML has total assets of $45 million, including cash reserves of $4 million. The outlay required for the new mine would be a major commitment. Christie believes that the company could borrow up to $9 million at an interest rate of about 8 percent. The mine's operating costs were projected at $900,000 per year, including $400,000 of fixed costs and $500,000 of variable costs. Christie thought these forecasts were accurate. The big question marks seemed to be the initial cost of the mine and the selling price of transcendental zirconium. Opening the mine, and providing the necessary machinery and ore- crunching facilities, was supposed to cost $10 million, but cost overruns of 10 percent or 15 percent were 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 about future prices. Some experts were projecting rapid price increases to as much as $14,000 per ton. On the other hand, there were pessimists saying that prices could be as low as $7,500 per ton. Christie did not have strong views either way: her best guess was that price would just increase with inflation at about 3.5 percent per year. (Mine operating costs would also increase with inflation.) Christie had wide experience in the mining business, and she knew that investors in similar projects usually wanted a nominal rate of return of at least 14 percent. You have been asked to assist Christie in evaluating this project. Lay out the base-case NPV analysis and undertake sensitivity, scenario, or break-even analyses as appropriate. Assume that SML pays tax at a 35 percent rate. For simplicity, also assume that the investment in the mine could be depreciated for tax purposes straight-line over seven years. What forecasts or scenarios should worry Christie the most? Where would additional information be most helpful? Is there a case for delaying construction of the new mine
