Question

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?)

1. Calculate the Sales Forecast for this Project: Y ear 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 - 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 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% 100.00% 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:
	-

Answer 1

	1	SALES FORCAST
		Year	1	2	3	4
	A	Tonnes Produced	750,000	810,000	830,000	720,000
	B	Contract sales Price	$60	$60	$60	$60
	C	Spot sales Price	$48	$48	$48	$48
	D=B*500000	Contract sales	$30,000,000	$30,000,000	$30,000,000	$30,000,000
	E=(A-500000)*C	Spot sales	$12,000,000	$14,880,000	$15,840,000	$10,560,000
	F=D+E	Total Sales	$42,000,000	$44,880,000	$45,840,000	$40,560,000
	2	CASH FLOW TODAY
	G	Equipment	$43,000,000
	H	Land	$7,300,000
	I=0.05*42000000	Net Working Capital	$2,100,000
	J=G+H+I	Total	$52,400,000
	3	OPERATING CASH FLOW
		Year	1	2	3	4	5
	K	Sales	$42,000,000	$44,880,000	$45,840,000	$40,560,000
	L=21*A	Variable Cost	$        15,750,000	$     17,010,000	$ 17,430,000	$ 15,120,000
	M	Fixed Cost	$3,700,000	$3,700,000	$3,700,000	$3,700,000
	O	Depreciation	$          6,144,700	$     10,530,700	$   7,520,700	$    5,370,700
	P=K-L-M-O	Earning Before Tax	$16,405,300	$13,639,300	$17,189,300	$16,369,300
	Q=P*0.38	Tax	$6,234,014	$5,182,934	$6,531,934	$6,220,334
	R=P-Q	Net Income	$10,171,286	$8,456,366	$10,657,366	$10,148,966
	S=R+O	Operating Cash Flow	$16,315,986	$18,987,066	$18,178,066	$15,519,666	($390,000)
		Depreciation Calculation
	T	MACRS Depreciation rate	14.29%	24.49%	17.49%	12.49%
	U=43000000*T	Annual Depreciation	$          6,144,700	$     10,530,700	$   7,520,700	$    5,370,700
	V	Accumulated depreciation	$          6,144,700	$     16,675,400	$ 24,196,100	$ 29,566,800
	W=43000000-V	Year End Book value	$        36,855,300	$     26,324,600	$ 18,803,900	$ 13,433,200
	4	NET WORKING CAPITAL CASH FLOW
		Year	1	2	3	4
	X=0.05*K	Beginning NWC	$2,100,000	$2,244,000	$2,292,000	$2,028,000
	Y	Ending NWC	$2,244,000	$2,292,000	$2,028,000	$0
	Z=X-Y	NWC Cash Flow	($144,000)	($48,000)	$264,000	$2,028,000
	a	Market value of equipment:	$25,800,000	(0.6*43 million)
	b	Book value of equipment:	$     13,433,200
	c=a-b	Gain/(Loss) on equipment:	$12,366,800
	d=c*0.38	Taxes on sale	$4,699,384
	e=a-d	After-tax salvage value:	$21,100,616
		Net cash flow for sale of equipment:
		5. Calculate the net cash flows for years 0 through 6
		N						A	B	C=A/(1.12^N)
		Time	Cash Flow(Initial)	(Operating )cash flow	NCWCash Flow	After Tax Salavage Value	Reclamation and chartiable deduction	Net Cash Flow(Sum of Cash Flows)	Cumulative Cash Flow	Present Value of Cash Flow
		0	($52,400,000)					($52,400,000)	($52,400,000)	$ (52,400,000)
		1		$16,315,986	($144,000)			$16,171,986	($36,228,014)	$    14,439,273
		2		$18,987,066	($48,000)			$18,939,066	($17,288,948)	$    15,098,107
		3		$18,178,066	$264,000			$18,442,066	$1,153,118	$    13,126,698
		4		$15,519,666	$2,028,000	$21,100,616		$38,648,282	$39,801,400	$    24,561,682
		5					($390,000)	($390,000)	$39,411,400	$        (221,296)
		6					$     2,774,000	$                                2,774,000	$42,185,400	$       1,405,395
							(7.3million*0.38)		SUM	$    16,009,859
		Net Present value	$        16,009,859
		Profitability Index	1.31	(16009859+52400000)/52400000
		Payback period=	2.94	Years	(2+(17288948/18442066)
		Internl Rate of Return	23.65%	(Using IRR function of excel over the net cash flow)
		YES, COMPANY SHOULD ACCEPT THE PROJECT
		NPV is positive
		IRR is higher than required return of 12%