Question

You own a coal mining company and are considering opening a new mine. The mine will cost $ 119.7 million to open. If this money is spent? immediately, the mine will generate $ 20.5 million for the next 10 years. After?that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost $ 1.7 million per year in perpetuity. What does the IRR rule say about whether you should accept this? opportunity? If the cost of capital is 8.2 %, what does the NPV rule?say?

-The NPV using the cost of capita o 8.2% is how much?

Answer 1

The cost of cleaning and maintenance at year 10, since it is a perpetuity = 1700000 / 0.082 = 20,731,707.32

Present value of cost of cleaning and maintenance = 20731707.32 / ( 1 + 0.082) = $19,160,542.81

Total value of initial investment = 119700000 + 19160542.81 = $138,860,542.8

Present value of annual cash flows:

Annual cash flow = 20500000

Number of years = 10

cost of capital = 8.2%

Present value of cash flows = $136,324,361.8

( Keys to use in a financial calculator PMT = 20500000, I/Y = 8.2%, N= 10, CPT PV)

IRR of the project = 7.79%

( Keys to use in a financial calculator to calculate IRR, CF0 = -138860542.8, CF1 = 20500000, CF2 = 20500000, CF3 = 20500000, CF4 = 20500000, CF5 = 20500000, CF6 = 20500000, CF7 = 20500000, CF8 = 20500000, CF9 = 20500000, CF10 = 20500000, IRR, CPT)

As per the IRR rule, the company should not accept the project as the IRR is less than the cost of capital.

NPV of the project = -138860542.8 + 136324361.8 = -2,536,181

Since NPV is negative, company should not accept the project.