Question

Pickins Mining

Pickins Mining is a midsized coal mining company with 20 mines located in Ohio, 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 Pickins, 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. Pickins has just been approached by Middle-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Pickins 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 $7.5 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, Pickins will need to purchase additional equipment, which will cost $46 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, Pickins 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 450,000 tons of coal per year at a price of $65 per ton. Pickins Mining feels that coal production will be 770,000 tons, 830,000 tons, 850,000 tons, and 740,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $82 per ton. Variable costs amount to $26 per ton and fixed costs are $3.9 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.

Pickins 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 $5.5 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 $7.5 million. Pickins 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. You need to show all your calculations. Should Pickins Mining take the contract and open the mine? Explain in detail, showing calculations,

Answer 1

Initial Investment
		Opportunity cost of land	$7,500,000
		Cost of equipment	$46,000,000
		Total initial cost	$53,500,000
		First years production	770000	tons
		Contract Sales	$             29,250,000	(450000*65)
		Sales in spot market	$             26,240,000	(770000-450000)*82
		Total sales in year 1	$             55,490,000
		Initial Working Capital required	$               2,774,500	(0.05*55490000)
		Present Value(PV) of Cash Flow=(Cashflow)/((1+i)^N)
		i=discount rate=Required rate of return=12%=0.12
		N=Year of cash flow
	N	Year	0	1	2	3	4	5	6	7	8
	A	Total initial cost	($53,500,000)
	B	Production in tonnes		770000	830000	850000	740000
	C=450000*65	Revenue fromContract sales		$        29,250,000	$     29,250,000	$           29,250,000	$       29,250,000
	D=(B-450000)*82	Revenue from sales in spot market		$        26,240,000	$     31,160,000	$           32,800,000	$       23,780,000
	E=C+D	Total Sales revenue		$        55,490,000	$     60,410,000	$           62,050,000	$       53,030,000
	F=B*26	Variable costs		$        20,020,000	$     21,580,000	$           22,100,000	$       19,240,000
	G	Fixed Costs		$3,900,000	$3,900,000	$3,900,000	$3,900,000
	H=D-E-F	Income before tax and depreciation		$        31,570,000	$     34,930,000	$           36,050,000	$       29,890,000
	I	MACRS 7 year depreciation rate		14.29%	24.49%	17.49%	12.49%
	J=I*$46 million	Annual Depreciation amount		$          6,573,400	$     11,265,400	$              8,045,400	$         5,745,400
	X	Accumulated depreciation		$          6,573,400	$     17,838,800	$           25,884,200	$       31,629,600
	K=H-J	Income before tax(after depreciation)		$        24,996,600	$     23,664,600	$           28,004,600	$       24,144,600
	L=0.38*K	Tax		$          9,498,708	$       8,992,548	$           10,641,748	$         9,174,948
	M=K-L	Net Income		$        15,497,892	$     14,672,052	$           17,362,852	$       14,969,652
	P=M+J	Operating Cash Flow		$        22,071,292	$     25,937,452	$           25,408,252	$       20,715,052
	Q	Net Working Capital Required	$               2,774,500	$          3,020,500	$       3,102,500	$              2,651,500
	R	Cash flow due to change in Working Capital	$             (2,774,500)	$            (246,000)	$           (82,000)	$                 451,000	$         2,651,500
		Terminal Cash Flow:
	S	Cash flow due to Cost of Reclamation						($5,500,000)
	T=0.38*$7.5 million	Cash flow due to charitable expense deduction							$      2,850,000
	U=0.6*$46 million	Salvage Value					$27,600,000
	V=$46 million-X	Book value at end of 4 years=					$       14,370,400
	W=0.38*(U-V)	Tax on gain on salvage					$5,027,248
	Y=U-W	After tax Cash flow from Salvage					$22,572,752
	Z=A+P+R+S+T+Y	Net Cash Flow	($56,274,500)	$        21,825,292	$     25,855,452	$           25,859,252	$       45,939,304	($5,500,000)	$      2,850,000
		Cumulative Cash Flow	($56,274,500)	($34,449,208)	($8,593,756)	$17,265,496	$63,204,800	$57,704,800	$60,554,800	SUM
	PV=Z/(1.12^N)	Present Value of Cash Flows	($56,274,500)	$        19,486,868	$     20,611,808	$           18,406,105	$       29,195,258	($3,120,848)	$      1,443,899	$29,748,590
		Payback Period=Period at which cumulative cash flow=zero
		Payback period=2+(8593756/25859252)=	2.33	Years
	NPV	Net Present Value=Sum of PV of cash flows=	$29,748,590
		Profitability Index=(NPV+Initial cash flow)/Initial cash flow
		Profitability Index=(29748590+56274500)/56274500
	PI	Profitability Index=	1.53
	IRR	Internal Rate of return	32.62%	(Using IRR function of excel over the cash flow)
		Should Pickins Mining take the contract and open the mine
		YES, they should take the contract and open the mine.
		Becasuse NPV is positive, PI is more than 1
		IRR is more than required rate of return