Question

This case study is from the Corporate Finance book, chapter 8 in the eBook (pg. 653 in the hard copy, page 261 in eBook). The case study will require you to perform a financial analysis and make some capital investment decisions for Bethesda Mining Company. You will need to prepare various operating cash flows in order to perform your analysis and make a recommendation. The case study is also stated below. Please complete the case study using the excel template found in Engage. As a reminder, please show all of your work! You cannot receive partial credit if you do not show your work. This means that you should use formulas and link to cells whenever possible instead of typing in numbers. This reduces the risk of input errors and it also makes it easier for me to follow your work and thought process. In the “real-world”, using formulas and linking cells is an essential skill to use because it makes the review process more efficient!

Case Study – Bethesda Mining Company Bethesda 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 Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda 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 purchased 10 years ago for $5.4 million. Based on a recent appraisal, the company feels it could receive $7.3 million on an after-tax basis if it sold the land today.

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. The land can then be used for other purposes. As they are currently operating at full capacity, Bethesda will need to purchase additional equipment, which will cost $43 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract only runs for four years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price. However, Bethesda plans to open another strip mine at that time and will use the equipment at the new mine.

The contract calls for the delivery of 500,000 tons of coal per year at a price of $60 per ton. Bethesda Mining feels that coal production will be 750,000 tons, 810,000 tons, 830,000 tons, and 720,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $48 per ton, Variable costs amount to $21 per ton and fixed costs are $3.7 million per year. The mine will require a net working capital investment of 5 percent of sales. The net working capital (“NWC”) will be built up in the year prior to the sales.

Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the company’s strip mines. It is estimated the cost of reclamation will be $3.9 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area as a condition to receive the necessary mining permits. This will occur in Year 5 and result in a charitable expense deduction of $7.3 million. Bethesda faces a 38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume a loss in any year will result in a tax credit.

You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index, net present value, and internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?

Required: 1. To analyze this project, we must calculate the incremental cash flows generated by the project. Since net working capital is built up ahead of sales, the initial cash flow depends in part on this cash outflow. Therefore you need to begin your analysis by calculating your sales forecast. Prepare the sales forecast in tab 1 of the excel workbook.

2. Calculate the initial cash outflow for this project; use tab 1 to calculate your answer.

3. Use tab 2 in the excel workbook to calculate your operating cash flows for this project for years 1 through 6.  

4. You will also need to calculate the net working capital cash flow each year, and the cash flow for the sale of the equipment. Calculate these amounts for this project in tab 3 of the excel workbook in Engage

5. Finally, using the net cash flows calculated above (operating cash flow, net working capital and after-tax salvage value), calculate the following for this project: a. Payback Period b. Profitability Index c. IRR d. NPV e. Recommendation – should the company accept or reject the project? Explain your recommendation (why should they accept or reject?)

Answer Format

You will be required to use the Week 6 Case Study Template that has been included on the Case Study page in Engage. The template is an excel spreadsheet and has been set up for ease of completion and grading.

1. Calculate the Sales Forecast for this Project:
	Year 1	Year 2	Year 3	Year 4
Tons produced
Contract sales price
Spot sales price
Contract sales
Spot sales
Total Sales
2. Cash Flow Today:
Equipment ______
Land _______
NWC _____
Total _____	-

3. Calculate the Operating Cash Flows for years 1 to 6
Tons produced
	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Sales:
Variable: costs:
Fixed costs:
Depreciation:
Earnings: before tax:
Tax:
Net Income:
Operating Cash Flow
Depreciation Calculation:			-
	Rate*	Depreciation
Yr 1	14.29%
Yr 2	24.49%
Yr 3	17.49%
Yr 4	12.49%
Yr 5	8.93%
Yr 6	8.92%
Yr 7	8.93%
Yr 8	4.46%
		100% 4. Calculate the Net Working Capital Cash Flow Year 1 Year 2 Year 3 Year 4 Beginning NWC Ending NWC NWC Cash Flow Market value of equipment: Book value of equipment: Gain/(Loss) on equipment: Taxes on sale After-tax salvage value: Net cash flow for sale of equipment: 5. Calculate the net cash flows for years 0 through 6 Time Cash Flow 0 1 2 3 4 5 6 5a - 5d - Calculate the following: Payback Period = Profitability Index = IRR = NPV = 5e. Recommendation:    Please show all work and functions using excel

Answer 1

1	Calculate the Sales Forecast for this Project
			Year 1	Year 2	Year 3	Year 4
	Tons Produced		750000	810000	830000	720000
	Contract Sales Price		$60	$60	$60	$60
	Spot Sales Price		$48	$48	$48	$48
	Contract Sales		$30,000,000	$30,000,000	$30,000,000	$30,000,000
	Spot Sales		$12,000,000	$14,880,000	$15,840,000	$10,560,000
	Total Sales		$42,000,000	$44,880,000	$45,840,000	$40,560,000
2	Cash flow today
	Equipment		-43000000
	Land	5400000	-7300000
	NWC		($2,100,000)
	Total		-52400000
3	Calculate the Operating Cash flows for years 1 to 6
	Tons Produced		Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	Sales		$42,000,000	$44,880,000	$45,840,000	$40,560,000
	Variable Costs		15750000	17010000	17430000	15120000
	Fixed Costs		3700000	3700000	3700000	3700000	3900000	7300000
	Depreciation		6144700	10530700	7520700	5370700
	Earnings Before Tax		16405300	13639300	17189300	16369300	-3900000	-7300000
	Tax @ 38%		6234014	5182934	6531934	6220334	-1482000	-2774000
	Net income		10171286	8456366	10657366	10148966	-2418000	-4526000
	Depreciation		6144700	10530700	7520700	5370700	0	0
	Operating Cash flow		16315986	18987066	18178066	15519666	-2418000	-4526000
	Depreciation Calculation
		Rate	Depreciation
	Yr 1	14.29%	6144700
	Yr 2	24.49%	10530700
	Yr 3	17.49%	7520700
	Yr 4	12.49%	5370700	29566800
	Yr 5	8.93%	3839900
	Yr 6	8.92%	3835600
	Yr 7	8.93%	3839900
	Yr 8	4.46%	1917800
		100.00%
4	Calculate the Net Working Capital Cash Flow		Year 1	Year 2	Year 3	Year 4
	Beginning NWC		$2,100,000	$2,244,000	$2,292,000	$2,028,000
	Ending NWC		$2,244,000	$2,292,000	$2,028,000
	NWC Cash flow		-144000	-48000	264000	2028000
	Market Value of Equipment		25800000
	Book Value of Equipment		13433200	(43000000-6144700-10530700-7520700-5370700)
	Gain/(Loss) on equipment		12366800
	Taxes on sale		4699384
	After-Tax Salvage Value		21100616
			0	1	2	3	4	5	6
	Capital Spending		-43000000				21100616
	Opportunity Cost		-7300000
	NWC		($2,100,000)	-144000	-48000	264000	2028000
	OCF			16315986	18987066	18178066	15519666	-2418000	-4526000
	Total Project Cash flow		-52400000	16171986	18939066	18442066	38648282	-2418000	-4526000	85257400
						53553118	1153118
	Payback Period		3 + 1153118/38648282		0.03
	Payback Period		3.03 years
	Profitability Index		Present Value of Future cash flows/Initial Capital Outlay
			85257400/52400000
			1.63
	IRR
	Using the IRR function in excel we get		20.97%
	Net Present Value		0	1	2	3	4	5	6
	Cash Flow		-52400000	16171986	18939066	18442066	38648282	-2418000	-4526000
	PV Factor @ 12%		1	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066
			-52400000	14439966.3	15098223.42	13127062.58	24560983	-1371973	-2292872
	NPV		11161390.7