THE GREEN COAL MINING COMPANY

Green Coal Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is sold under contract, with excess production sold on the spot market. The coal mining industry, especially high-sulfur coal operations such as Green Coal, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to improved market demand for high-sulfur coal. Green Coal has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Green Coal Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land. Green Coal will need to purchase the land, which will cost $5 million. The land cannot be depreciated for tax purposes and will be worthless at the end of the contract (i.e., a market value of zero). In addition, Green Coal is currently operating at full capacity. Green Coal will also need to purchase additional necessary equipment, which will cost $64 million. The equipment will be depreciated on a four-year straight-line schedule. The contract runs for only four years. At that time, the coal from the site will be entirely mined. The company estimates that the equipment will be worthless at the end of the contract (i.e., a market salvage value of zero). The contract calls for the delivery of 500,000 tons of coal per year at a price of $80 per ton. Green Coal Mining feels that coal production will be 600,000 tons, 700,000 tons, 800,000 tons, and 500,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $70 per ton. Variable costs amount to $30 per ton, and fixed costs are $4,000,000 per year. The mine will require a net working capital (NWC) investment. Based on the companys experience, NWC is estimated based on 5% of next years sales. Strip mining is a process where the layers of topsoil above a coal vein are removed, and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. Green Coal will be responsible for reclaiming the land at the termination of the mining. This will occur in Year 5. The company uses an outside company for the reclamation of all the companys strip mines. It is estimated the cost of reclamation will be $2.5 million. This expense is tax deductible. Green Coal faces a 28 percent tax rate and has a 12.5 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit, as the company overall is profitable. You have been approached by the president of the company with a request to analyze the project. Calculate the net present value (NPV) and internal rate of return (IRR) for the new strip mine. The company is not sure about the cost of capital estimates and would like you to include a sensitivity analysis based on a potential error of 1%.

Notes for solution:

1. Project termination in year 5: Although the production ends at the end of year 4, you will need to take into account the year-5 reclamation cost when calculating the NPV and IRR. Assume that the firm is profitable so this expense is tax deductable.

2. Net working capital calculation: Net working capital is 5% of next years sales. That means that in year 4, NWC is closed since there are zero sales in year 5.

3. Sensitivity analysis: Include NPV calculations based on a cost of capital of 11.5% and 13.5%.

4. Points allocation: a. Sales 20 points b. Costs 30 points c. Cash flow adjustments 30 points d. NPV and IRR 20 points