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Please use Excel to solve the assignment and submit as an excel spreadsheet. Bethesda Mining Company...

Please use Excel to solve the assignment and submit as an excel spreadsheet.

Bethesda Mining Company Based on a Mini Case presented in the textbook Ross, S.A., R.W. Westerfield and J. Jaffe, Corporate Finance, McGraw Hill/Irwin. 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 million. Based on a recent appraisal, the company feels it could receive $4.2 million on an aftertax basis if it sold the land today. Strip mining is a process where the layers of topsoil above vein are removed and the exposed soil is removed. Some time ago, the company would simply remove the coil and leave the land in an unusable condition. Changes in the mining regulations now force the a company to reclaim the land; that is, when 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 $32 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. 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 $40 per ton. Bethesda Mining feels that call production will be 530,000 tons, 630,000 tons, 700,000 tons, and 630,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $45 per ton. Variable costs amount to $15 per ton, and fixed costs are $2,200,000 per year. The mine will require a net working capital investment of 2 percent of sales. The NWC will be built up in the year prior to 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 million. After the land is reclaimed, the company plans to denote 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 $5 million. Bethesda faces a 40 percent tax rate and has a 10 percent required return on new strip mine projects. Assume that 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. Should Bethesda Mining take the contract and open the mine?

Solutions

Expert Solution

Question - Calculate the payback period, profitability index, net present value and internal rate of return for the new strip mine?

Answer - Before we calculate the metrics mentioned above, it is important to find out the Free Cash flow for the project. Below is the Free cash flow for the project .

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Production capacity in tons - A                530,000                630,000                700,000                630,000 $                      -   $                 -  
Sales under contract in ton - B                500,000                500,000                500,000                500,000 $                      -   $                 -  
Selling price per ton - C $                     40 $                     40 $                     40 $                     40 $                      -   $                 -  
Sales - D = B x C $       20,000,000 $       20,000,000 $       20,000,000 $       20,000,000 $                      -   $                 -  
Spot sales in ton - E = A - B                  30,000                130,000                200,000                130,000 $                      -   $                 -  
Selling price per ton - F $                     45 $                     45 $                     45 $                     45 $                      -   $                 -  
Spot Sales G = F x E $         1,350,000 $         5,850,000 $         9,000,000 $         5,850,000 $                      -   $                 -  
Total Sales H = D + G $       21,350,000 $       25,850,000 $       29,000,000 $       25,850,000 $                      -   $                 -  
Variable Cost per Unit - I $                     15 $                     15 $                     15 $                     15 $                      -   $                 -  
Total Variable Cost - J = A x I $         7,950,000 $         9,450,000 $       10,500,000 $         9,450,000 $                      -   $                 -  
Fixed Cost - K $         2,200,000 $         2,200,000 $         2,200,000 $         2,200,000 $                      -   $                 -  
Depreciation (Note 1) - L $         4,572,800 $         6,716,921 $         3,622,228 $         2,134,298 $                      -   $                 -  
Total Cost - M = J + K + L $       14,722,800 $       18,366,921 $       16,322,228 $       13,784,298 $                      -   $                 -  
Earnings Before Tax (H - J) $         6,627,200 $         7,483,079 $       12,677,772 $       12,065,702 $                      -   $                 -  
Less: Tax @40% $         2,650,880 $         2,993,231 $         5,071,109 $         4,826,281 $                      -   $                 -  
Net Income $         3,976,320 $         4,489,847 $         7,606,663 $         7,239,421 $                      -   $                 -  
Adjustments
Depreciation - N $         4,572,800 $         6,716,921 $         3,622,228 $         2,134,298 $                      -   $                 -  
Working Capital $            427,000 $            517,000 $            580,000 $            517,000 $                      -   $                      -   $                 -  
Working Capital for cash flow - O (Note 2) $           (427,000) $             (90,000) $             (63,000) $              63,000 $            517,000 $                      -   $                 -  
Plant & Equipment (Purchases)/Sales - P $      (32,000,000) $                      -   $                      -   $                      -   $       17,501,501 $                      -   $                 -  
Land cost - Q $        (4,200,000) $                      -   $                      -   $                      -   $                      -   $                      -   $                 -  
Land reclaiming cost - R $                      -   $                      -   $                      -   $                      -   $                      -   $        (3,000,000) $    2,000,000
Free cash flow N+O+P+Q+R $      (36,627,000) $         8,459,120 $       11,143,769 $       11,291,891 $       27,392,220 $        (3,000,000) $    2,000,000

Note:

1) Depreciation -

MARCS depreciaion schedule Year 1 Year 2 Year 3 Year 4
7 year MACRS depreciation rate 14.29% 24.49% 17.49% 12.49%
Opening balance of asset $       32,000,000 $       27,427,200 $       20,710,279 $       17,088,051
Less: Depreciation for the year $         4,572,800 $         6,716,921 $         3,622,228 $         2,134,298
Closing Balance of asset $       27,427,200 $       20,710,279 $       17,088,051 $       14,953,753

2) Working Capital  

Working capital required for the project is 2% of the next year sales. However, only incremental working capital is considered for the purpose of the cash flow. Year 1 working capital to be considered = Year 0 working capital requirement - Year 1 working capital requirement.

3) Cash flow from sale of machine

Sale of Machine Year 4
Selling price @ 60% of Purchase cost $       19,200,000
Book Value at the end of Year 4 $       14,953,753
Profit on sale of asset $         4,246,247
Tax on profit @ 40% $         1,698,499
Net Realisable value of machine $       17,501,501

Machine being used for another project is not relevant for the current project.

4) Land reclamation cost - Land reclamation cost is an outflow in year 4 and the tax benefit for charitable expenses is allowed at 40% of $5 million in Year 6 and hence, this will be an inflow in Year 6.

a) Payback period -

Cumulative cash flow should be found out for arriving at payback

Year

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