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 $4 million. Based on a recent appraisal, the company feels it could receive $6.5 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. Because it is currently operating at full capacity, Bethesda will need to purchase additional necessary equipment, which will cost $95 million. The equipment will be depreciated on a seven-year MACRS schedule. 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, Bethesda plans to open another strip mine at that time and will use the equipment at the new mine.

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The contract calls for the delivery of 500,000 tons of coal per year at a price of $86 per ton. Bethesda Mining 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 $77 per ton. Variable costs amount to $31 per ton, and fixed costs are $4,100,000 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 $2.7 million. In order to get the necessary permits for the strip mine, the company agreed to donate the land after reclamation 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 million. Bethesda faces a 38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit.

QUESTION:

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?

Answer 1

1. NPV= 16.86 million

2. IRR= 19%

3. Profitability index= 1.65

4. Payback= 3 years + (91112000-79068570)/70697830 = 3.17 years

Year	After tax cost of old land	Cost of equipment	Recovery of equipment	Net working capital (NOTE 2)	Cost of reclamation	Charitable expense	Operating CF (NOTE1)	Net cash flows
0	6500000	-95000000		-2612000				-91112000
1				-231000			23089090	22858090
2				-192500			28482490	28289990
3				539000			27381490	27920490
4			46617640	2496500			21583690	70697830
5					-1674000			-1674000
6						2280000		2280000
							NPV	$            16,857,864.51
							IRR	19.00%
							PI	165.04%
NOTE 1
Year	Production	Sales	Variable cost	Fixed cost	Depreciation	PBT	Tax	PAT	OperatingCash flow
0
1	620000	52240000	19220000	4100000	13575500	15344500	5830910	9513590	23089090
2	680000	56860000	21080000	4100000	23265500	8414500	3197510	5216990	28482490
3	730000	60710000	22630000	4100000	16615500	17364500	6598510	10765990	27381490
4	590000	49930000	18290000	4100000	11865500	15674500	5956310	9718190	21583690
WORKING CAPITAL- NOTE 2
Year	Production	Sales	NWC	Working capital cash flow
0				-2612000
1	620000	52240000	2612000	-231000
2	680000	56860000	2843000	-192500
3	730000	60710000	3035500	539000
4	590000	49930000	2496500	2496500
CAPITAL RECOVERY-NOTE 3
Sale price	57000000
Book value	29678000
Gain on sale	27322000
Tax on gain	10382360
Post tax capital recovery	46617640

Formulae for computation attached