Dick Davies, the owner of Davies Gold Mining, is evaluating a new gold mine in Tanzania. Barry Koch, the company's geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Barry has taken an estimate of the gold deposits to Andy Marshall, the company's financial officer. Andy has been asked by Dick to perform an analysis of the new mine and present his recommendation on whether the company should open the new mine.

Andy has used the estimates provided by Barry to determine the revenues that could be expected from the mine. He has also projected the expense of opening the mine, and the annual operating expenses. If the company opens the mine, it will cost $500 million today, and it will have a cash outflow of $80 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the following table. Davies Gold Mining has a 12 per cent required return on all of its gold mines.

Year

Cash flow ($)

0

-500,000,000

1

60,000,000

2

90,000,000

3

170,000,000

4

230,000,000

5

205,000,000

6

140,000,000

7

110,000,000

8

70,000,000

9

-80,000,000

In discussing the payback period rule Dick asks Andy to highlight its strengths and weaknesses.What are they? [5 marks]

In analysing the mine, Andy advises Dick that this mine is riskier than other mines in the Davies Gold Mining portfolio and so the discount rate should increase.Explain what impact will this have on the cash flows of the project.