Question

Mr. Hunter, CEO of MT Mining Company (MTMC), received a report from the engineering department. The report describes a proposed new mine on the North Ridge of MT. A gold mine had been discovered on the land owned by MTMC. The land is now leased to another company for $300,000 a year. The lease is going to expire but can be renewed with the same condition. Tests indicated that this mine can produce 90,000 ounces gold for the first year and the production can increase 10 percent for the next four years then decreases 15 percent for next three years. The resources will be exhausted by the end of the eighth year. MTMC is currently very conservatively financed. Mr. Hunter believes that MTMC can raise $60 million by issuing bond with 9 percent coupon interest rate. However, when the bond is issued, the market interest can fluctuate in the range of 7% to 11%. The initial cost of the project includes the purchase of necessary machinery ($50 million), one-time environmental protection fee of $2.5 million, and designing fee of $6.5 million. The project needs $1 million as working capital. The fixed operating cost of the mine is $850,000 per year. The mine needs to hire 20 engineers and managers, 200 workers at the beginning of the project. The average salary for engineers and managers is $40,000 for the first year and average wage for workers is $25,000 for the first year. Both salaries and wages will increase at a constant rate of 10%. The contracts signed with 10 of the engineers and managers are for four years. Starting from year 4, each year 20 workers will be transferred to other mines. The variable cost (excluding wages and salaries) for producing gold is $1.5 per ounce. The machines will be depreciated by MACRS. According to MT Environment Protection Law, the mine must restore the site to its original environment condition. It is estimated that the cost of restoration will be $1.5 million. When the restoration is finished, the government will return $2 million of environmental fee. The current price of gold is $300 per ounce. As for the gold price by the time when the project starts, there are three different opinions about the gold price in the future. Most people believe the price will remain the same as the present price. Optimists believe that the gold price will increase 10% while pessimists predict that gold price will further decline by 5%. MTMC is in the 35% tax bracket. Now you are hired as CFO of MTMC. Mr. Hunter is asking you to make a project analysis and make a presentation to the board of directors within a week.

Answer 1

The project is good investment opportunity. The NPV of the project is $34 million at base case and $23 million at worst case scenarios (gold price drops by 5% and interest rate increases to 11%) vs. the opportunity cost of the current lease of $1.6 million. The best case scenario (gold price increases by 10% and interest rate decreases to 7%) NPV is $51 million. the analysis is as below-

Year	1	2	3	4	5	6	7	8
Opportunity cost of current lease	300,000	300,000	300,000	300,000	300,000	300,000	300,000	300,000
Sales
Production	90,000	99,000	108,900	119,790	131,769	112,004	95,203	80,923
Base price of gold	300	300	300	300	300	300	300	300
Revenue generated	27,000,000	29,700,000	32,670,000	35,937,000	39,530,700	33,601,095	28,560,931	24,276,791
Costs
Purchase of machinery	50,000,000
Depriciation schedule (MACRS)	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
Env. Fee	2,500,000
Working capital	1,000,000
Cost of restoration								1,500,000
Return on env fee								2,000,000
Debt raised	60,000,000
Operating cost	850,000	850,000	850,000	850,000	850,000	850,000	850,000	850,000
Salaries
Engineers & Managers hired	20	20	20	20	-	-	-	-
Salary of engineer & manager	40,000	44,000	48,400	53,240	58,564	64,420	70,862	77,949
Total engineer and manager salary	800,000	880,000	968,000	1,064,800	-	-	-	-
Workers hired	200	200	200	200	180	160	140	120
Salary of worker	25,000	27,500	30,250	33,275	36,603	40,263	44,289	48,718
Total workers salary	5,000,000	5,500,000	6,050,000	6,655,000	6,588,450	6,442,040	6,200,464	5,846,151
Variable cost per ounce	1.5	1.5	1.5	1.5	1.5	1.5	1.5	1.5
Total variable cost	135,000	148,500	163,350	179,685	197,654	168,005	142,805	121,384
Cash flow schedule- (Base case)
Year	1	2	3	4	5	6	7	8
Revenue generated	27,000,000	29,700,000	32,670,000	35,937,000	39,530,700	33,601,095	28,560,931	24,276,791
Debt raised	60,000,000							(60,000,000)
Purchase of machinery	(50,000,000)
Env. Fee	(2,500,000)
Working capital	(1,000,000)							1,000,000
Cost of restoration	-							1,500,000
Return on env fee	-							2,000,000
Operating cost	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)
Total all Salaries	(5,800,000)	(6,380,000)	(7,018,000)	(7,719,800)	(6,588,450)	(6,442,040)	(6,200,464)	(5,846,151)
Base case Interest payment- 9%	(5,400,000)	(5,400,000)	(5,400,000)	(5,400,000)	(5,400,000)	(5,400,000)	(5,400,000)	(5,400,000)
Total variable cost	(135,000)	(148,500)	(163,350)	(179,685)	(197,654)	(168,005)	(142,805)	(121,384)
Depriciation	(10,000,000)	(16,000,000)	(9,600,000)	(5,760,000)	(5,760,000)	(2,880,000)	-	-
Net taxable income	(48,685,000)	921,500	9,638,650	16,027,515	20,734,597	17,861,050	15,967,663	16,559,256
Tax payment @35%		322,525	3,373,528	5,609,630	7,257,109	6,251,367	5,588,682	5,795,740
Profit after tax	(48,685,000)	598,975	6,265,123	10,417,885	13,477,488	11,609,682	10,378,981	10,763,516
Free Cashflow to Firm	(38,685,000)	16,598,975	15,865,123	16,177,885	19,237,488	14,489,682	10,378,981	10,763,516
Present Value	(35,490,826)	13,971,025	12,250,786	11,460,821	12,503,047	8,639,724	5,677,658	5,401,846
NPV of Project	34,414,081
Opportunity cost of current lease	300,000	300,000	300,000	300,000	300,000	300,000	300,000	300,000
Present Value	275,229	252,504	231,655	212,528	194,979	178,880	164,110	150,560
NPV of opportunity cost	1,660,446

Pessistic scenario-

Cash flow schedule
Year	1	2	3	4	5	6	7	8
Revenue generated	25,650,000	28,215,000	31,036,500	34,140,150	37,554,165	31,921,040	27,132,884	23,062,952
Debt raised	60,000,000							(60,000,000)
Purchase of machinery	(50,000,000)
Env. Fee	(2,500,000)
Working capital	(1,000,000)							1,000,000
Cost of restoration	-							1,500,000
Return on env fee	-							2,000,000
Operating cost	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)
Total all Salaries	(5,800,000)	(6,380,000)	(7,018,000)	(7,719,800)	(6,588,450)	(6,442,040)	(6,200,464)	(5,846,151)
Pessimistic Interest payment- 11%	(6,600,000)	(6,600,000)	(6,600,000)	(6,600,000)	(6,600,000)	(6,600,000)	(6,600,000)	(6,600,000)
Total variable cost	(135,000)	(148,500)	(163,350)	(179,685)	(197,654)	(168,005)	(142,805)	(121,384)
Depriciation	(10,000,000)	(16,000,000)	(9,600,000)	(5,760,000)	(5,760,000)	(2,880,000)	-	-
Net taxable income	(51,235,000)	(1,763,500)	6,805,150	13,030,665	17,558,062	14,980,995	13,339,616	14,145,416
Tax payment @35%		(617,225)	2,381,803	4,560,733	6,145,322	5,243,348	4,668,866	4,950,896
Profit after tax	(51,235,000)	(1,146,275)	4,423,348	8,469,932	11,412,740	9,737,647	8,670,750	9,194,521
Free Cashflow to Firm	(41,235,000)	14,853,725	14,023,348	14,229,932	17,172,740	12,617,647	8,670,750	9,194,521
Present Value	(37,830,275)	12,502,083	10,828,597	10,080,843	11,161,103	7,523,490	4,743,197	4,614,420
NPV of Project	23,623,458
Opportunity cost of current lease	300,000	300,000	300,000	300,000	300,000	300,000	300,000	300,000
Present Value	275,229	252,504	231,655	212,528	194,979	178,880	164,110	150,560
NPV of opportunity cost	1,660,446

Optimistic scenario-

Cash flow schedule
Year	1	2	3	4	5	6	7	8
Revenue generated	29,700,000	32,670,000	35,937,000	39,530,700	43,483,770	36,961,205	31,417,024	26,704,470
Debt raised	60,000,000							(60,000,000)
Purchase of machinery	(50,000,000)
Env. Fee	(2,500,000)
Working capital	(1,000,000)							1,000,000
Cost of restoration	-							1,500,000
Return on env fee	-							2,000,000
Operating cost	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)	(850,000)
Total all Salaries	(5,800,000)	(6,380,000)	(7,018,000)	(7,719,800)	(6,588,450)	(6,442,040)	(6,200,464)	(5,846,151)
Optimistic Interest payment- 7%	(4,200,000)	(4,200,000)	(4,200,000)	(4,200,000)	(4,200,000)	(4,200,000)	(4,200,000)	(4,200,000)
Total variable cost	(135,000)	(148,500)	(163,350)	(179,685)	(197,654)	(168,005)	(142,805)	(121,384)
Depriciation	(10,000,000)	(16,000,000)	(9,600,000)	(5,760,000)	(5,760,000)	(2,880,000)	-	-
Net taxable income	(44,785,000)	5,091,500	14,105,650	20,821,215	25,887,667	22,421,159	20,023,756	20,186,935
Tax payment @35%		1,782,025	4,936,978	7,287,425	9,060,683	7,847,406	7,008,314	7,065,427
Profit after tax	(44,785,000)	3,309,475	9,168,673	13,533,790	16,826,983	14,573,753	13,015,441	13,121,508
Free Cashflow to Firm	(34,785,000)	19,309,475	18,768,673	19,293,790	22,586,983	17,453,753	13,015,441	13,121,508
Present Value	(31,912,844)	16,252,399	14,492,859	13,668,207	14,679,989	10,407,103	7,119,892	6,585,242
NPV of Project	51,292,847
Opportunity cost of current lease	300,000	300,000	300,000	300,000	300,000	300,000	300,000	300,000
Present Value	275,229	252,504	231,655	212,528	194,979	178,880	164,110	150,560
NPV of opportunity cost	1,660,446