How do you calculate the NPV's for walking the dragline and contractor stripping?

9B13N025 Scott McCarthy wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright 2014, Richard Ivey School of Business Foundation Version: 2014-01-20 THE COMPANY In 2001, a Queensland company, Zeta Mining (Zeta), was formed with the objective of mining the coal resources of the Bowen Basin in Central Queensland, Australia. Since then, Zeta had become one of the world's largest producers of metallurgical coal, operating a number of open-cut mines in the Bowen Basin. The mines were estimated to produce 6,000 million tonnes of coal over the next 120 years. Used in the manufacture of steel, the coal that was sold offshore was shipped from the company-owned coal terminal, which loaded about 450 ships per year for 70 customers in more than 20 countries. The major export destinations were Japan, South Korea, China and India. The company's investment in the area was estimated at about $8 billion1 and included machinery, accommodation, high voltage infrastructure, ports, water management, roads and tailings management. One of the most important and expensive pieces of machinery used on the mines were the draglines. In 2012, Zeta used the net present value (NPV) methodology to determine whether to \"walk\" one of its draglines to another mine. THE SETTING Draglines are used to remove the mine overburden, that is, the dirt, rock and other geological waste sitting on top of the coal. The dragline buckets can hold up to 400 tonnes. The draglines are imported from the United States, shipped by sea to Mackay or Gladstone. The components are then transported by road to a specially built pad near the mine to operate the dragline, which is then put together on site. The assembly can take up to eight months and requires a specialist assembly crew of 40 people. From the time Zeta decides to purchase a new machine, it can be up to two and a half years until it is ready to be put to use. The draglines weigh about 3,400 tonnes and have a top speed of just 120 metres per hour. A new dragline can cost approximately $220 million, including fabrication, transport and assembly. Recently, Zeta needed to decide where the dragline originally intended for the southern pit of the New Find mine could be situated after a change in the mine plan meant that that pit would not be advancing for 1 All currencies are in AU$ unless otherwise indicated. Authorized for use only by Colin Davies in BUSA 203-01 at Pacific Lutheran University from Sep 06, 2016 to Dec 16, 2016. Use outside these parameters is a copyright violation. ZETA MINING: WALKING THE DRAGLINE 9B13N025 another 10 years and the dragline was thus no longer required there. Because this change involved increasing production in the northern pit, earthmoving and mining equipment had to be relocated there. To \"walk\" the dragline the six kilometres to the northern pit, it had to cross two public roads and a railway line owned and operated by Aurizon (formerly Queensland Rail).2 The trains using the tracks were electric and were powered through lines running above the trains and parallel with the tracks. The traffic on the roads could be temporarily controlled and diverted at minimal cost, causing only minimal inconvenience to public traffic. The rail crossing was much more problematic because Aurizon would only permit the train line, power lines and all supporting materials (sleepers, rock ballast and network/communication cabling) to be out of service for 48 hours. Potentially, Zeta would be subject to significant fines if the track was out of commission for any time above the 48 hours, including any interference caused by inclement weather. THE DETAILS As Zeta's project evaluation director for the sector that included the New Find mine, Connor Horwill's role was to financially analyze the project and to recommend whether Zeta should undertake the task of moving the dragline. Zeta's policy was to use the NPV model on such large-scale projects and have the project evaluation director present a recommendation to the chief financial officer (CFO) of the entire Bowen Basin area. The CFO would then consider the NPV result together with any other relevant factors and make a final decision about the project.3 Horwill had total authority in determining the appropriate cash flows for the NPV model. These were generated by his team in conjunction with various other departments. He calculated the cost of moving the dragline, building temporary roads and removing and replacing the railway lines and power at $10 million. The discount rate to be used in the analysis was determined at a higher company level using the weighted average cost of capital (WACC) model. Like many large corporations, Zeta used a whole-ofcompany based WACC plus a premium for country risk. In any case, Horwill was simply given the rate by the CFO to use in all analyses; for this project, it was 9 per cent. Further, Horwill was directed to consider the project as an incremental comparison analysis by balancing the business case optimized with the investment with the business case optimized without the investment.4 This approach required Horwill and his team to identify a number of alternatives to moving the dragline. Only two alternatives were considered viable: using the contractor's excavator and truck fleet to strip out the overburden or purchasing another dragline and assembling it near the northern pit. After further consideration, the new dragline alternative was dismissed because of the significant capital and time required before it would be operational. While the contractor model was far more labour intensive, at the appropriate level of staffing, it could achieve the same rate of removal of overburden as the dragline. It was estimated for the analysis that all the overburden would be removed after a five-year period. (Coal extraction in the pit could begin about three months after stripping was completed.) The pit would have a useful revenue generating life of approximately 25 years after this five-year period. Contractor stripping was often used when draglines were not feasible because of where the mine was located or specific issues, such as the mine's unstable footings. This approach also had two clear advantages since Zeta had previously used contractors on other sites: first, their induction costs would be 2 An example of a dragline walking from YouTube is www.youtube.com/watch?v=-NhAR_qJVZk, accessed December 23, 2013. 3 To support, though not dominate NPV analysis, Zeta also used internal rate of return, payback period and the capital efficiency ratio to assess projects. 4 \"Optimized without\" does not mean not doing the project, it means how you would add value if you didn't undertake the preferred investment. Authorized for use only by Colin Davies in BUSA 203-01 at Pacific Lutheran University from Sep 06, 2016 to Dec 16, 2016. Use outside these parameters is a copyright violation. Page 2 9B13N025 low; and second, the contractors could be employed without having to go to tender. Horwill's project evaluation team determined induction expenses (which were tax deductible at the company tax rate of 30 per cent) to be $1 million in Year 1 and a further $250,000 in Years 3 and 5. Using contractors would allow Zeta to immediately sell the dragline for $19 million with payment received in two instalments of 50 per cent each. The first payment would be received at the end of the first year and the second pay ment 12 months later. The current book value of the dragline was zero as a result of an attractive depreciation and investment allowance offered to the mining industry. Any tax payable on disposal of the dragline was to be included in the analysis when the cash was received.5 The contractor contract was casual and could be suspended by Zeta at any time. For instance, Zeta might decide that coal prices or significant exchange rate movements made the mine uneconomical.6 The cost of employing the contractors comprised three tax deductible parts: an hourly rate per contractor, a flat fee per year and an initial upfront engagement fee. The hourly rate accorded with the contractor's level, whether as labourer or supervisor. (The estimated labour hours required to work at the same rate of removal as the dragline would cost are shown in Exhibit 1. The rates of pay for labourers are shown in Exhibit 2, while supervisors cost an extra $15 per hour.) The flat fee per year was set at 15 per cent of the total labour cost for the year (excluding the engagement fee) but covered the cost of fuel, maintenance and other expenses for the contractor. The engagement fee of $750,000, a significant expense for Zeta, arose because of the casual nature of the contract. The fee was payable immediately, and no part of it was refundable no matter how long the contract remained in place. The dragline required some modifications owing to the slightly different configuration of the northern pit. Because this pit shared its eastern border with a major public road, excavation depth on that side was restricted. This meant that the roads descending into the pit had to be steeper and narrower, requiring steering and suspension adjustments at an immediate cost of $1,100,000. Ongoing maintenance was $300,000 per year with an additional major service of $150,000 being required in Year 3. An annual salary of $260,000 was payable to the dragline operator, while fuel, oil and other running costs were estimated at $2 million per year. Both these figures were forecast to grow at 10 per cent per year. The adjustments to the dragline, the ongoing maintenance and major service costs, operator salary, all running costs and the up-front costs associated with \"walking\" the dragline were all tax deductible.7 Horwill estimated that, during the five-year period to remove the overburden, if the mine was mothballed for any reason, it could be sold at approximately $4 million less per year off the current sale price. At the end of the five-year period, the dragline would have just scrap value and hence would not be considered in the analysis. As a community service, the dragline could be donated to the local council as part of a tourist attraction to promote the significance of the mines to the local district. THE DECISION Horwill was instructed by the CFO to have a recommendation to her within the next month. While she made it clear that the final decision would take into account various other factors, his recommendation should be based solely on the NPV analysis. 5 In fact, this is a simplifying assumption for the case, as under Australian taxation law, any profit on sale of assets is taxable at the company tax rate at the time of the sale, not when the cash is received. 6 The price of coal has halved from its highs in 2011. Much of this is due to oversupply in the market and the slowing down of the economies of China and India. Similarly, in October 2010, the AU$ appreciated to be at parity with the US$, the first time since it was floated in 1983. In May 2011, it reached a high of US$1.0939/AU$, but, in mid 2013, it depreciated below parity to be, in August 2013, at US$0.8900/AU$. 7 In fact, the adjustments to the dragline would most likely be capitalized, that is, added to the value of the dragline, and would therefore be depreciated rather than expensed in the year as a tax deduction. For simplicity in the case, we have expensed the cost in the year it was incurred. Authorized for use only by Colin Davies in BUSA 203-01 at Pacific Lutheran University from Sep 06, 2016 to Dec 16, 2016. Use outside these parameters is a copyright violation. Page 3 Page 4 9B13N025 EXHIBIT 1: CONTRACTOR HOURS PER YEAR Contractor Labourer Supervisor Year 1 80,000 12,000 2 80,000 12,000 3 90,000 12,000 4 90,000 13,000 5 100,000 15,000 EXHIBIT 2: CONTRACTOR HOURLY RATE Contractor Labourer Source: Company estimates. Year 1 75 2 80 3 85 4 90 5 95 Authorized for use only by Colin Davies in BUSA 203-01 at Pacific Lutheran University from Sep 06, 2016 to Dec 16, 2016. Use outside these parameters is a copyright violation. Source: Company estimates