Question
Harrington Explorations Inc. is interested in expanding its copper mining operations in Indonesia. The area has long been noted for its rich deposits of copper
Harrington Explorations Inc. is interested in expanding its copper mining operations in 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 deposit) over five years toward a zero value. Because Harrington faces a corporate tax rate of 30%, the tax savings are significant.
The companys geologists also estimate that the ore will be of about the same purity as existing deposits, meaning 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 of 15,000 tons per year.
Harringtons 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 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 firms cost of capital was estimated to be 9.5%. The risk-free rate of interest on five-year Treasury bonds is currently 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 firms CFO sees the results of the analysis, he suggests that something must be wrong because his own analysis using conventional methods (i.e., expected cash flows and the firms 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 CFOs concerns?
Please use below template for solution:
PROBLEM 11-8 | ||||||||
Given | Solution Legend | |||||||
Initial investment | $ 60,000,000 | = Value given in problem | ||||||
Total Ore Quantity | 75,000 | tons | = Formula/Calculation/Analysis required | |||||
% Pure Copper/ton | 15% | = Qualitative analysis or Short answer required | ||||||
Life of project | 5 | years | = Goal Seek or Solver cell | |||||
Ore mined each year | 15,000 | tons | = Crystal Ball Input | |||||
Cost/ton for processing | $ 150.00 | = Crystal Ball Output | ||||||
Tax rate | 30% | |||||||
Risk free rate | 5.5% | |||||||
WACC | 9.5% | |||||||
Growth in copper prices | 12% | |||||||
Forward Price Curve | Copper Price/Ton | Expected Prices per Ton | ||||||
2011 | $ 7,000 | $ 7,000 | change dates: future dates are 2016-2020 | |||||
2012 | 7,150 | 7,840 | ||||||
2013 | 7,200 | 8,781 | ||||||
2014 | 7,300 | 9,834 | ||||||
2015 | 7,450 | 11,015 | ||||||
Solution | ||||||||
a. | ||||||||
Year | Revenues | Processing Costs | Depreciation/ Depletion | NOI | NOPAT | Plus: Depreciation | Project FCF | |
2011 | ||||||||
2012 | ||||||||
2013 | ||||||||
2014 | ||||||||
2015 | ||||||||
b. | ||||||||
NPV | $(60,000,000.00) | |||||||
c. | ||||||||
Year | Revenues | Processing Costs | Depreciation/ Depletion | NOI | NOPAT | Plus: Depreciation | Project FCF | |
2011 | ||||||||
2012 | ||||||||
2013 | ||||||||
2014 | ||||||||
2015 | ||||||||
NPV | ||||||||
Tracking portfolio | ||||||||
Year | Forward price | Expected Price | Gain (loss) on FOR | Bond Payoffs | Total payoffs | |||
2011 | $ 7,000 | $ 7,000 | ||||||
2012 | 7,150 | 7,840 | ||||||
2013 | 7,200 | 8,781 | ||||||
2014 | 7,300 | 9,834 | ||||||
2015 | 7,450 | 11,015 | ||||||
Cost at t = 0 | ||||||||
Total cost (Track. Port) | ||||||||
Cost of investment | ||||||||
Savings | ||||||||
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