Question

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 aftertax
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 $49 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 $70 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 $64 per ton,
Variable costs amount to $29 per ton and fi xed costs are $4.2 million per year. The mine will require a net working
capital investment of 5 percent of sales. The 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, profi tablitity index, net present value, and internal rate of return for the new strip mine.
Should Bethesda Mining take the contract and open the mine?

Answer 1

Workings:
Sale value(60%*49)	29.4		MACRS Rates
Less:Carrying value of the equipment at end Year 4(1-68.76%)*49=	15.3076		14.29
Gain on sale	14.0924		24.49
Tax on gain at 38%*14.0924	5.3551		17.49
So, after-tax sale proceeds(29.4-5.3551)	24.0449		12.49	68.76
			8.93
			8.92
			8.93
			4.46	31.24
			100

(Fig.in mlns.)	Year 0	1	2	3	4
Initial investment
Sale value of land	-7.3
Addl.Equipment	-49
After-tax sale value					24.04
NWC(5%*Next yr. sales)	-4.15	-4.34	-4.41	-4.05
NWC recovered					16.95
CAPEX & NWC cash flows	-60.45	-4.34	-4.41	-4.05	40.99

Operating cash flows	Year 0	1	2	3	4	5
Contract delivery(500000*70)		35	35	35	35
Sale volume in spot market		750000	810000	830000	720000
Sale value in Mlns at $ 64/ton		48	51.84	53.12	46.08
Total sale value		83	86.84	88.12	81.08
Less:
Variable costs(29/ton)		21.75	23.49	24.07	20.88
Fixed costs		4.2	4.2	4.2	4.2
MACRS depn.		7.00	12.00	8.57	6.12
Total Opg. Exp.		32.95	39.69	36.84	31.20
EBT (sale value-opg.exp.)		50.05	47.15	51.28	49.88
Less: Tax at 38%		19.02	17.92	19.49	18.95
EAT		31.03	29.23	31.79	30.93
Add Back depn.		7.00	12.00	8.57	6.12
Opg. Cash flow		38.03	41.23	40.36	37.05
After-tax Cost of reclamation(3.9*(1-38%))						-2.418
After-tax Charitable exp. Dedn.						2.774
Net opg. Cash flows		38.03	41.23	40.36	37.05	0.36
CAPEX & NWC cash flows(from above)	-60.45	-4.342	-4.406	-4.054	40.992
Net annual cash flows	-60.45	33.6898	36.827	36.3096	78.03764	0.356
PV F at 12%	1	0.89286	0.79719	0.71178	0.63552	0.56743
PV at 12%	-60.45	30.08018	29.35829	25.84448	49.59433	0.20200
NPV	74.6293
IRR	55%
PI= (NPV/initial Investment)-1
PI=1+(74.63/60.45)
2.23
Pay-back period
Net annual cash flows	-60.45	33.6898	36.827	36.3096	78.03764	0.356
Cumulative cash flow	-60.45	-26.7602	10.0668	46.3765	124.4141	124.77
Pay back period= 1+(26.76/36.83)
1.73	Years
Bethesda Mining can take the contract and open the mine