Harrington Explorations Inc. is interested in expanding it copper mining operations Indonesia. The area has long been noted for its rich deposits of copper, ore with copper prices at near record levels, the company is considering an investment of $60 million to open operations into a new vein of ore that was mapped by company geologists four years ago. The investment would be expensed (a combination of depreciation of capital equipment and depletion costs associated with using up the ore deposits) over five years toward a zero value. Because Harrington faces a corporate tax rate of 30%, the tax savings are significant. The company's geologists also estimate that the ore will be of about the same purity as existing deposits, such that it will cost $150 to mine and process a ton of ore containing roughly 15% pure copper. The company estimates that there are 75,000 tons of ore in the new vein that can be mined and processed over the next five years at a pace o 15,000 tons per year. Harrington's CFO asked one of his financial analysts to come up with an estimate of the expected value of the investment using the forward price curve for copper as a guide to the value of the future copper production. The forward price curve for the price per ton of copper spanning the next five years when the proposed investment would be in production is as follows: 2016 - $7,000/Ton 2017 - $7,150/ton 2018 - $7,200/ton 2019 - $7,300/ton 2020 - $7,450/ton In a study commissioned by the CFO last year, the firm's cost of capital was estimated to be 9.5%. The risk-free rate of interest on five year Treasury bonds is 5.5%. A. Estimate the after-tax (certainty-equivalent) project free cash flows for the project over its five year productive life.

B. Using the certainty-equivalent valuation methodology, what is the NPV of the project?

C. Assume now that the analyst estimates the NPV of the project using the certainty equivalent methodology and it is negative. When the firm's CFO sees the results of the analysis, he suggests that something must be wrong because his own analysis using conventional methods (expected cash flows and the firm's weighted average cost of capital) produces a positive NPV of more than $450,000. Specifically, he estimates that the price of copper for 2016 would indeed be $7,000 per ton but that this would increase by 12% per year over the five-year life of the project. How should the analyst respond to the CFO's concerns?

PROBLEM 11-8 Given Initial investment Total Ore Quantity % Pure Copper/ton Life of project Ore mined each year Cost/ton for processing Tax rate Risk free rate WACC Growth in copper prices $ $ Forward Price Curve 2016 2017 2018 2019 2020 Solution Legend 60,000,000 75,000 tons 15% 5 years 15,000 tons 150.00 30% 5.5% 9.5% 12% Copper Price/Ton $ 7,000 7,150 7,200 7,300 7,450 = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output Expected Prices per Ton ### 7,840 8,781 9,834 11,015 change dates: future dates are 2016-2020 Solution a. Revenues Processing Costs Depreciation/ Depletion NOI NOPAT Plus: Depreciation Project FCF Revenues Year 2016 2017 2018 2019 2020 Processing Costs Depreciation/ Depletion NOI NOPAT Plus: Depreciation Project FCF Bond Payoffs Total payoffs b. NPV c. Year 2016 2017 2018 2019 2020 NPV Tracking portfolio Year 2016 2017 2018 2019 2020 Cost at t = 0 Total cost (Track. Port) Cost of investment Savings Forward price Expected Price $ 7,000 $ 7,000 7,150 7,840 7,200 8,781 7,300 9,834 7,450 11,015 Gain (loss) on FOR