Question

Calculate NPV: Evaluate the two options using NPV analysis and clearly identify which of the two alternatives results in a higher valuation for Rio Tinto. Include a brief commentary of your analysis.

Option 1: Building a “Crusher” and 13-kilometre Conveyor The construction and installation of a new “Crusher” and 13-kilometre conveyor will cost $24 million. In addition, an ANFO facility will also need to be constructed at a cost $8.2 million. This facility will need to be supplied with slurry pumps, mixed flotation systems and other equipment at a total cost of $7 million. Rio Tinto’s reserve fleet of autonomous Caterpillar Haulage trucks will meet the needs for this project, however until recently, the fleet has been earning a rental income of $1,030,000 per 2 year. The additional iron ore mined is expected to generate a revenue of $18 million per year, which is forecasted to increase by 2.5% per annum due to higher demand from China. As a result of the additional complexities involved with the construction and management of this project, 7 new engineers (yearly salary per engineer $145,000) will replace 11 existing engineers (yearly salary per engineer $105,000). The 1000 additional construction labour required for this project is expected to cost $6.2 million per annum for the duration of the project. For tax reasons you will expense the cost of the ANFO facility immediately. The cost for the construction of the new “Crusher”, 13-kilometre conveyor and associated slurry pumps, mixed floatation systems and other equipment will be depreciated over three years using the straight-line method. Due to the nature of the mining project, the crusher and associated systems and equipment will likely have a salvage value of $12 million at the end of three years. Finally, the required net working capital is $6.3 million which will be returned at the end of the project’s lifetime.

Option 2: Outsourcing the supply of ore Alternatively, to achieve the same iron ore mined from Option 1, Rio Tinto can contract BHP to supply the required iron ore. Based on the amount of iron ore required, BHP has quoted a total cost of $25 million. BHP has however offered this rate on the condition that Rio Tinto pays 24% of the total cost in advance in the beginning of the year (i.e. Y0), with the remaining paid in equal instalments thereafter. Rio Tinto will process the iron ore using existing facilities at an expected cost of $6.2 million per year. Interest expenses related to this project is expected to $3.8 million per year.

[For simplicity we will assume a project life time of 3 years – that is Year 0, Year 1, Year 2 and Year 3]

Interest on all debt securities is paid twice-yearly and the corporate tax-rate is 30 percent.

WACC = 4.25%

Answer 1

Based on the above data and below calculations, Option 2 seems to be better for Rio Tinto.

Comments on the Calculations:

Depreication on straight line basis is calculated by: (Total Depreciable Investment - Salvage Value) / NUmber of Years

Rental Income from Fleet is not added in the P/L balance in Option 1 since its a notional loss and cannot be taxed. Its added to cash flows though. In Option 2, its added as the income in P/L. Since the question mentioned the revenue in 2 years, the amount is divided by 2 to calculate yearly revenues.

The expenses saved from change of engineers is added to cash flow. But not to P/L. In option 2, the old engineers salaries are added.

Interest expense is assumed for only Option 1 due to investments in capital expenses. Since the same facilities will be utilized in Option 2, now working capital or interest expense is assumed.

Tax Rate	30%
WACC	4.25%
ANFO	(82,00,000)
Crusher	(2,40,00,000)
Ancilliary	(70,00,000)
Total Investment	(3,92,00,000)
Total Depreciable Investment	(3,10,00,000)
Salvage Value	1,20,00,000
Depreciation / Year	(63,33,333)
Fleet Cost / Year	5,15,000
Old Engineers Cost	11,55,000
New Engineers Cost	10,15,000
Savings / Year	1,40,000
Option 1
Revenue Growth	2.50%
Working Capital	-	63,00,000	63,00,000	-
Change in Working Capital		(63,00,000)	-	63,00,000
Year	0	1	2	3
Revenue		1,80,00,000	1,84,50,000	1,89,11,250
Salaries		(10,15,000)	(10,15,000)	(10,15,000)
Labour		(62,00,000)	(62,00,000)	(62,00,000)
Depreciation		(63,33,333)	(63,33,333)	(63,33,333)
Interest Expense		(38,00,000)	(38,00,000)	(38,00,000)
Profit Before Tax		6,51,667	11,01,667	15,62,917
Tax		(1,95,500)	(3,30,500)	(4,68,875)
Net Income		4,56,167	7,71,167	10,94,042
Plus: Depreciation		63,33,333	63,33,333	63,33,333
Plus: Change in WC		(63,00,000)	-	63,00,000
Plus: Savings from Salaries		1,40,000	1,40,000	1,40,000
Plus: Salvage Value				1,20,00,000
Plus: Fleet Cost Rental		(5,15,000)	(5,15,000)	(5,15,000)
Plus: Investment	(3,92,00,000)
Total Cash Flow	(3,92,00,000)	1,14,500	67,29,500	2,53,52,375
Discount Factor	1.00	0.96	0.92	0.88
NPV	(1,05,21,759)
Option 2
Year	0	1	2	3
Revenue		1,80,00,000	1,84,50,000	1,89,11,250
Rental Income		5,15,000	5,15,000	5,15,000
Salaries		(11,55,000)	(11,55,000)	(11,55,000)
Expenses		(62,00,000)	(62,00,000)	(62,00,000)
Minus: Material Cost	(60,00,000)	(63,33,333)	(63,33,333)	(63,33,333)
Profit Before Tax	(60,00,000)	48,26,667	52,76,667	57,37,917
Tax	0	(14,48,000)	(15,83,000)	(17,21,375)
Net Income	(60,00,000)	33,78,667	36,93,667	40,16,542
Total Cash Flow	(60,00,000)	33,78,667	36,93,667	40,16,542
Discount Factor	1.00	0.96	0.92	0.88
NPV	41,84,634