Question

Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South Dakota. Dan Dority, the company’s geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Dan has taken an estimate of the gold deposits to Alma Garrett, the company’s financial officer. Alma has been asked by Seth to perform an analysis of the new mine and present her recommendation on whether the company should open the new mine.

Alma has used the estimates provided by Dan to determine the revenues that could be expected from the mine. She has also projected the expense of opening the mine and the annual operating expenses. If the company opens the mine, it will cost $850 million today, and it will have a cash outflow of $75 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the following table. Bullock Mining has a 12 percent required return on all of its gold mines.

Year	Cash Flow
0	−$850,000,000
1	170,000,000
2	190,000,000
3	205,000,000
4	265,000,000
5	235,000,000
6	170,000,000
7	160,000,000
8	105,000,000
9	−75,000,000

1. Construct a spreadsheet to calculate the payback period, internal rate of return, modified internal rate of return, and net present value of the proposed mine.
2. Based on your analysis, should the company open the mine?
3. What would your opinion be if Bullock Mining evaluated the risk of spending $850 million and decided in the current environment, they required a 30% required return on all of its new gold mines? Why?

Answer 1

1. The payback period is 4.08 as can be visible from the below table -

Year	Outflow (Amount '000,000)	Inflow (Amount '000,000)	Cumulative inflow (Amount '000,000)
0	-850
1		170	170
2		190	360
3		205	565
4		265	830
5		235	1065
6		170	1235
7		160	1395
8		105	1500
9	-75

Below table present the calculation of Net present value -

Year	Outflow (Amount '000,000)	Inflow (Amount '000,000)	PV @12%	Pv of inflows and outflows
0	-850		1	-850.00
1		170	0.8929	151.79
2		190	0.7972	151.47
3		205	0.7118	145.91
4		265	0.6355	168.41
5		235	0.5674	133.35
6		170	0.5066	86.13
7		160	0.4523	72.38
8		105	0.4039	42.41
9	-75		0.3606	-27.05
			Net present value	74.79

Internal rate of return is where the present value of inflows equal outflows - 14.67% as visible from the below table -

Year	Outflow (Amount '000,000)	Inflow (Amount '000,000)	PV @14.67%	Pv of inflows and outflows
0	-850		1	-850.00
1		170	0.8721	148.26
2		190	0.7606	144.51
3		205	0.6633	135.97
4		265	0.5784	153.29
5		235	0.5045	118.55
6		170	0.4399	74.79
7		160	0.3837	61.39
8		105	0.3346	35.13
9	-75		0.2918	-21.89
			Net present value	0.00

2. As the NPV of the project is positive, that means, the above project is giving the return of more than 12% and thus it is viable to proceed with it.

3. As the gold mine is a risky project and investing in it requires significant amount of investment, so any investor would require a good amount of return for investing at it and gold itself is the most valuable product, so asking a return of 30% is reasonable in some sense