Question

Proposed project:
Alchemy Mines is considering an investment in the rights to a platinum mine.
Initial investment
The owner of the mine will sell the rights to Alchemy Mines at a cost of $1,000,000
payable immediately. Purchase of the rights entitles Alchemy Mines to all mining rights
provided mining commences within one year and continues without interruption until the
entire deposit is recovered and the land restored in compliance with regulatory
requirements. If mining does not commence in one year, the title to the mine reverts to
the seller.
Expected operating variables
The firm has made the following assumptions regarding operating cash flows for the
mine:
Recoverable platinum: 100,000 ounces
Current market price of platinum: $889.60 per ounce
Expected price of platinum in one year: $904.00 per ounce
Expected fixed costs of mining and refining: $750,000
Expected variable costs of mining and refining: $873.50 per ounce
Cost to restore the land and remediate environmental damage: $525,000
No taxes are paid on profits from the project
If the firm mines the platinum, all cash in- and out-flows from mining and selling the
platinum and for remediation will occur in one year.
Additional Information:
The firm estimates additional economic variables as follows:
Risk free interest rate equals 2.5%
Expected market return: 11.50%
Beta for platinum mining and smelting: 0.662
Standard deviation of annual returns on platinum prices: 0.1995
1. Use net present value analysis to determine whether the firm should accept the
proposed Alchemy Mines project.
a. Determine the amount and timing of all expected cash flows for the proposed
project.
b. Determine the appropriate discount rate (using CAPM).
c. Calculate NPV.

d. Indicate whether Alchemy Mines should accept the project based on it NPV
and explain.
2. Use option pricing analysis to determine whether Alchemy Mines should accept
the proposed platinum mine project.
a. Determine whether the project cash flows have the characteristics of a put
option or a call option.
b. Find the implicit “strike price,” that is, the expected spot platinum price at
which the firm will elect to commence mining and processing rather than just
walk away from the project. (Remember that for an option, the option premium is
a sunk cost and does not affect the decision to exercise.)
c. Calculate the option value of the mine using the Black-Scholes options pricing
model.
Note: You can calculate the option value for a single ounce of platinum
using per ounce price and costs, then multiply that by the total amount of
platinum to get the total option value of the mine. Alternatively, you can
calculate the option value using the total price of platinum and the total
costs.
d. Compare the option value of the mine to the cost to acquire rights to the mine
to determine whether to accept the project.
e. Indicate whether Alchemy Mines should accept the project and explain.

Answer 1

		CASH FLOWS
		Year	0	1
	a	Mines Cost	($1,000,000)
	b	Recoverable Platinum(Ounce)		100,000
	c	Expected Price per ounce		$904.00
	d=b*c	Revenue		$90,400,000
	e=b*$873.50	Variable Costs		-$87,350,000
	f	Fixed Costs		($750,000)
	g	Restoration cost		($525,000)
	h=d+e+f+g	Profit		$1,775,000
		Year	Net Cash Flow
		0	($1,000,000)
		1	$1,775,000
	b	APPROPRIATE DISCOUNT RATE
		Discount Rate =Rf+Beta*(Rm-Rf)
		Rf=Risk Free Rate=2.5%
		Beta=0.662
		Rm=Expected Market Return=	11.50%
		Discount Rate =2.5+0.662*(11.5-2.5)	8.46%		5.958	8.458
	c	Present Value of Year1 Cash Flow=	$1,636,548	(1775000/1.0846)
		NPV=-1000000+1635548=	$636,548
	d	Alchemy Mines Should Accept the Project
		NPV is positive and it will create wealth