Maxine Peru, the CEO of Peru Resources, hardly noticed the plate of savory

quenelles de brochet and the glass of Corton Charlemagne 94 on the table

before her. She was absorbed by the engineering report handed to her just

as she entered the executive dining room.

The report described a proposed new mine on the North Ridge of Mt. Zircon.

A vein of transcendental zirconium ore had been discovered there on land

owned by Ms. Perus company. 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.

Peru Resources was a family-owned business with total assets of $45 million,

including cash reserves of $4 million. The outlay required for the new mine

would be a major commitment. Fortunately, Peru Resources was

conservatively financed, and Ms. Peru believed that the company could

borrow up to $9 million at an interest rate of about 8 percent.

The mines operating costs were projected at $900,000 per year, including

$400,000 of fixed costs and $500,000 of variable costs. Ms. Peru 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. Ms. Peru 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.) Ms. Peru had wide experience in the

mining business, and she knew that investors in similar projects usually

wanted a forecasted nominal rate of return of at least 14 percent.

You have been asked to assist Ms. Peru by writing an essay to

evaluate this project. The major direction of the report should beable to assist Ms. Peru to lay out the base-case NPV analysis and

undertake sensitivity, scenario, or break-even analyses as

appropriate. Assume that Peru Resources pays tax at a 35 percent rate.

Every section should be clearly defined in introduction, and the calculations

should be discussed in the framework that has been stated in introduction.

For simplicity, also assume that the investment in the mine could be

depreciated for tax purposes straight-line over 7 years. What forecasts or

scenarios should worry Ms. Peru the most? Where would additional

information be most helpful? Is there a case for delaying construction of the new mine?