Question

DSW is a midsized coal mining company with 20 mines located in Hessen region in central Germany. 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 DSW, has been hard-hit by environmental regulations and warmer than expected winter 2014/2015 and 2016/2017. 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. DSW has just been approached by SudenKraftwerk Company with a request to supply coal for its electric generators for the next four years. DSW does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Broken on 5,000 acres of land purchased 10 years ago for € 5 million. Based on a recent appraisal, the company feels it could receive € 6.2 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. 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. Because it is currently operating at full capacity, DWS will need to purchase additional necessary equipment, which will cost € 78 million. The equipment will be depreciated on a seven-year linear basis. The contract runs for only 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 in four years. However, DSW 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 €85 per ton. DWS feels that coal production will be 620,000 tons, 680,000 tons, 730,000 tons, and 590,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of € 80 per ton but the spot prices are highly volatile. The fact should be taken into consideration in the analysis. Variable costs amount to € 27 per ton, and fixed costs are € 3,700,000 per year. The mine will require net working capital of 5 percent of sales. The NWC will be built up in the year prior to the sales.

DSW 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 € 2.4 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. This will occur in year 6 and result in a charitable expense deduction of € 6.5 million. DSW faces a 19 percent tax rate. Assume that a loss in any year will result in a tax credit.

You have been approached by the CFO of the company with a request to analyze the project.

Calculate the payback period, profitability index, net present value, internal rate of return for the new strip mine. Please prepare also sensitivity analysis for the project.

To calculate WACC of DSW assume that it is rather illiquid company with capitalization on the level of € 680 million, beta equals 1,25, outstanding interest bearing debt on the level of € 300 million and cash level of € 78 million.[1] The current EBIT of DSW amounts € 80 million and the gross financial costs equals € 28 million.

Should DSW Mining take the contract and open the mine taking into consideration the risk of the project?

Answer 1

Computation of WACC

Capital funds = 680 million

Debt funds = 300 million

Earnings available to share holders = (EBIT - Interest)(1-Tax rate)

= ( 80 million - 28 million) (1-0.19) = 42.12 million

Interest net of tax = 28 million (1-.19) = 22.68 million

WACC = [( 42.12m/680m) (680m/980m)] + [(22.68m/300m)(300m/980m)]

= 0.06612 = 6.612%

Computation of present value of cashflows after tax

Particulars	1stYear	2nd year	3rd year	4th year	5th year	6th year	7th year
sales revenue	(500000tons 85) +(120000tons 80)	(500000tons 85) +(180000tons 80)	(500000tons 85) +(230000tons 80)	(500000tons 85) +(90000tons 80)
	52,100,000	56,900,000	60,900,000	49,700,000
Variable cost	62000027	68000027	73000027	59000027
	16,740,000	18,360,000	19,710,000	15,930,000
Contribution	35,360,000	38,540,000	41,190,000	33,770,000
Depreciation	11.143m	11.143m	11.143m	11.143m
Fixed cost	3,700,000	3,700,000	3,700,000	3,700,000
cost of reclamation					3.4m
cost of land donated						6.5m
Earnings before tax	20.517m	23.697m	26.347m	18.927m	(3.4m)	(6.5m)
Tax @ 19%	3.898m	4.502m	5.006m	3.5961m	0.646m	1.235m
Earnings after tax	16.619m	19.195m	21.341m	15.331m	0.646m	1.235m
Depreciation	11.143	11.143	11.143	11.143
Cashflows after tax	27.762	30.338	32.484	26.474	0.646m	1.235m
PvF(6.612%,n)	0.938	0.880	0.825	0.774	0.726	0.681
Present value of cashflows	26.04	26.70	26.80	20.50	0.47	0.84

Computation of present value of cashflows

Cost of machinery = 78m

Computation of payback period

Payback period is defined as recovery period of initial investment

payback period = 78m - 27.762m-30.338m = 58.1m

= 2years +[ (78m-58.1)/32.482]

= 2.613 years

Computation of profitability Index

Profitability Index = Present value of cash inflows /Present value of cash outflows

= {26.04m+26.70m+26.8m+20.5m+0.47m+0.84m}/78m

= 1.3

Computation of Net Present Value(NPV)

NPV = Present value of cash inflows - Present value of cash outflows

= 101.35m - 78m = 23.35m

Computation of Internal rate of return

Computation of NPV @10%

Cashflows after tax	27.762	30.338	32.484	26.474	0.646m	1.235m
PvF(10%,n)	0.909	0.826	0.751	0.683	0.621	0.564
Present value of cashflows	25.23	25.06	24.4	18.08	0.40	0.696

NPV = 93.866m - 78m = 15.866

IRR = 6.612% + {[23.35m/(23.35-15.866)]3.388}

= 17.182%

Since, NPV is positive. Company can take up the project.

Notes

m represents million

Depreciation per year = 78m/7years = 11.143