Question

Bathesda 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-suffer coal operations such as Bathesda, 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 been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next 4 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 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 7-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.

The contract calls for the delivery of 500,000 tons of coal per year at a price of $86 per ton. Bathesda 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.

Bathesda 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 and 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. Bathesda faces a 25 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 NPV –should the company take the contract and open the mine? In addition, calculate the Internal Rate of Return (IRR), Profitability Index (PI), Accounting Rate of Return (ARR), and Payback Period.

Answer 1

							KEY OUTPUT	NPV=	$3,626,062
								IRR=	15.42%
								Payback	3.27
Part1:INPUTS
Equipment Cost	$95,000,000		Market Value of equipment in year4	$57,000,000	(60%*95 million)
Opportunity Cost of Land	$6,500,000		Tax Rate		25%
Total cash flow	$101,500,000		WACC		12%
Part2:Depreciation and Amortization Schedule
					Years	Accumulated
				InitialCost	1	2	3	4	Depreciation
				$95,000,000
		7 YearDepreciation Rate		14.29%	24.49%	17.49%	12.49%
		Depreciation Amount		$13,575,500	$23,265,500	$16,615,500	$11,865,500	$65,322,000
		Ending book Value					$29,678,000
		(InitialCost-Accu.Deprcn)
Part3:Net Salvage Value in year 4
		Estimated Market value in year4	$57,000,000
		Book value in year4	$29,678,000
		Expected gain or loss	$27,322,000
		Taxes paid or tax credit	($6,830,500)	(27322000*25%)
		Net Cash flow from salvage	$50,169,500
Part4:Projected net cash flow