You and a friend from university days have been tramping through the wet BC hinterland hunting moose and whatever else might cross your path. One day, right in the middle of the bush, both of you almost mistake two gentlemen for some live game. Later, during a conversation with them, you discover that one is a geologist and the other is an engineer. They tell you they have been looking at a bentonite clay deposit that lies over a hill about 2 km away. Bentonite is a type of clay formed by the alteration of volcanic ash. You both decide to go with them to have a look.
The site is covered with sand and gravel overburden and some trees but there are several outcrops of clay. The geologist and engineer tell you that there may be 200,000 tonnes of clay. Laboratory test results, some of which they show you, indicate the deposit is a high-quality calcium bentonite or clumping clay with little grit or impurities. After stripping the overburden, the deposit could be mined using a loader and a truck. There is a 1.5 km dirt road which connects with a paved road leading to the town where you and your friend are staying. After a few minutes of discussion, the geologist and engineer say they have to leave but give you their business cards which say they work for a company called ACME Mines. They are the sole owners of the company which owns the mineral rights to the property.
Later that day you and your friend are eating at the only restaurant in town. Being a person who knows clay, you say that the purity and lack of grit in the clay would make it relatively easy and cheap to process and sell to cat litter manufacturers. Bentonite has a number of uses other than cat litter. Your friend is skeptical. At that moment in walks ACME Mines. You invite them to your table and ask how much they want for the mineral rights to the property. $3.5 million is the price. Your friend almost falls off his chair but recovers. By early evening, ACME Mines have convinced you and your friend that a bentonite business could work – the trick is to find the buyers for the clay. Your friend then asks ACME Mines why they aren’t in the cat litter business. They say they owe too much money to friends and relatives and need to sell. Your friend appreciates their honesty but still wants to crunch some numbers.
Next morning your friend asks what processing would have to be done to get the clay to retail cat litter standards. You say likely some screening and drying. If the dirt road could be upgraded, truckloads of the raw bentonite could be brought to the town and stored in a shelter which is available for rent. But, you say, it is essential to verify that the deposit does in fact have 200,000 tonnes of clay and that its quality is uniform. This will require trenching and sampling. You both decide that it would be conservative to assume that half the resource is available, i.e., 100,000 tonnes of clay.
The next question is how much clay could be mined per year. Given the rain and snowfall in the area, there might be only a seven to eight-month mining “season”. After some discussion about truck sizes and cycle times (vague memories of a surface mining course you both took) it is decided that it should be feasible to mine 9,000 tonnes of bentonite per year (40 tonnes per day for 225 days). Therefore, a conservative estimate of the mine life is 10 years.
You estimate the capital costs required to buy the processing equipment and to build the processing plant next to the shelter to be $800,000. You also suggest that another $500,000 will be needed for trenching and sampling the deposit, clearing overburden, and upgrading the dirt road. About $150,000 would be needed for marketing once the quality of the deposit is confirmed. Buying and installing the equipment, construction of the plant, obtaining permits, trenching, sampling, overburden removal should all take one year at which time the mining operation can begin.
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Your friend says: “So for $3.5M up-front and another $1.4M spent over one year, we would have an operating clay mine. How much would it cost to mine, process, package, and transport one tonne of bentonite?” You guess $23 per tonne. Your friend is now really excited and you start to think he needs to spend more time with people. He scribbles a few things:
• Assume equipment is straight-line depreciated
• Salvage value after ten years $260,000
• Tax rate 32%
Discussion turns to the required return. You say: “To raise the cash needed we would have to sell stocks and stock options, take out loans, re-mortgage our houses, beg, and borrow from friends just to raise the $4.4M. Also, to work on this project we would probably have to quit our jobs. For that kind of risk-taking I want a high return – 25% - and I think we can get it.”
A) [2 marks] Assuming continuous cash flow and continuous discounting, use the symbols below and the appropriate discount factors to write the equation for the NPV of the project.
K Acquisition cost
Kg Trenching, sampling, overburden removal, road upgrade, marketing
Ke Equipment cost
T Annual tonnage
p Price per tonne
c Cost per tonne
τ Tax rate
M Annual depreciation
S Salvage value
B) [4 marks] What should be the minimum price per kilogram of bentonite to obtain a 25% return?
C) [2 marks] Draw a cash flow diagram of this operation, and label the costs of acquisition, the first-year costs,
the after-tax revenues, and the salvage (the amplitude of the after-tax cash flows is unknown, but their
timing is).
D) [2 marks] The NPV (and the required price per tonne) is most sensitive to any costs occurring near
time = 0. Likely the acquisition cost K will not change, but Kg and Ke could vary.
Which of Kg and Ke should you and your friend be concerned about and why?

Hints and help:
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• This problem is not as complicated as it looks. You have to find the price that gives NPV = 0 for a discount rate of 25%. The NPV equation contains a number of terms; collect these terms in a present value cash flow table, sum the PVs and you are almost there. The depreciation tax shields are only available at tax time but treat them as if they are available all year. It turns out this does not matter as the tax shields are small compared to other terms.
Extra information
• The numbers in this problem are fairly realistic. Don’t forget the price you find is a minimum price and that some tax incentives for industrial mineral operations have not been used. When you have solved the problem, have a look at retail prices of a bag of clumping clay cat litter (it’s available from www.amazon.ca) to see how lucrative this business can be, even if the retailer applies a 100% markup. Another aspect of these kinds of operations is that they are relatively easy to stop and re-start in response to demand. Thus, more than 9,000 tonnes per year could be mined and a stockpile might be considered – enough to keep one busy all winter bagging clay.