Question

QUESTION 3 Deep Down Mining Corp. (DDM) is a publicly traded, Canadian-based mining operation with various mines located throughout Canada. Investors benchmark earnings compared to market expectations and to other similar companies.
DDM’s loan facility with a consortium of banks stipulates that DDM’s long-term debt cannot exceed 1.5 times the book value of its equity. DDM is not currently in danger of breaching this covenant, but is planning some acquisitions that will increase its debt significantly and bring its debt-to-equity ratio much closer to the stipulated maximum. Wherever feasible, DDM prefers to adopt accounting policies that increase short-term profitability, to keep the equity base strong.
As part of its compensation package, DDM awards bonuses to its executives on an annual basis. The primary criterion considered by the board of directors when determining the size of the bonuses to be awarded to the executives overseeing the production side of the mine is the firm’s actual earnings before interest and taxes (EBIT) compared to the budgeted EBIT for the year.
Projected financial results for the Xavier mine, an open-pit gold mine in northern British Columbia, are shown below. However, projections are notoriously unreliable, because the selling price of gold per ounce fluctuates significantly from year to year. When prices are high, the mine increases production volume and when prices are low, production volume is reduced. The results below are based on expected high price/high volume in Year 2 and low price/low volume in Year 3, but the opposite situation might unfold, or prices might be constant. Extraction costs are stable per tonne processed, and are projected to increase by inflation only.
Projected financial results — Xavier mine (in $’000s)
Year 1 Year 2 Year 3 Volume 110,000 154,000 88,000 Sales price $1,500 $2,100 $1,250 Revenue1 $165,000 $323,400 $110,000 Extraction2 88,000 126,896 74,687 Administration3 20,000 20,600 21,218 Earnings before interest, taxes, depreciation and amortization (EBITDA) $ 57,000 $175,904 $ 14,095 Depreciation4 10,000 10,000 10,000 EBIT $ 47,000 $165,904 $ 4,095

1 1,000,000 tonnes mined; 0.11 ounces recovered per tonne processed; Year 1, C$1,500 sales price per ounce; 1,000,000 tonnes mined × 0.11 = 110,000; 110,000 × $1,500 = $165 million; Year 2, C$2,100 sales price per ounce; 1,400,000 tonnes mined × 0.11 = 154,000; 154,000 × $2,100 = $323.4 million; Year 3, C$1,250 sales price per ounce; 800,000 tonnes mined × 0.11 = 88,000; 88,000 × $1,250 = $110 million
2 C$800 per ounce recovered with an inflation factor of 3% per year. For year 1: 110,000 × $800 = $88 million; Year 2 154,000 × ($800 × 1.03) = $126.896 million; Year 3 88,000 × ($800 × 1.03 × 1.03) = $74.687 million
3 Inflation factor of 3% per year. Will not be materially affected by changes in throughput.
4 Depreciation expense excluding the new Jaw Crusher.
A brand-new class of equipment has recently been purchased by DDM for the Xavier mine.
Details of the equipment
• Jaw Crusher model XY2 is to be used in the Xavier mine and costs $10.5 million. • The manufacturer advises that the maximum capacity is 1.6 million tonnes per year. Your engineering staff has indicated that this throughput is probably on the high side and could only be achieved in ideal circumstances. • Your counterparts in other mining companies that use similar machinery advise that the maximum capacity of this machine, when allowing for shutdowns for maintenance and emergency repairs, is closer to 1.4 million tonnes per year. They also advise that, as the machine ages, the capacity declines by about 5% per year, because the time lost for maintenance and repair shutdowns increases as the machine ages. • The manufacturer advises that the estimated useful life of the Jaw Crusher model XY2 varies depending on its usage, per the following table: Yearly production (% of maximum) Estimated maximum useful life 75% to 100% 10 years 16 million tonnes 50% to 75% 15 years 18 million tonnes 25% to 50% 25 years 20 million tonnes

• Your research has determined that it is difficult to resell Jaw Crushers that are more than five years old due to the ongoing advances of technology for this type of equipment, as well as the prohibitive dismantling and shipping costs.

Other information
• DDM uses the cost model to subsequently measure the value of all its property, plant, and equipment (PPE). • DDM currently uses the straight-line method to depreciate all its depreciable nonmining PPE. The depreciation method used by DDM to depreciate PPE directly involved in mining operations is governed by the nature of the PPE. Straight-line, double-declining-balance, and units-of-production methods are all used in various circumstances at other mines. When DDM uses the double-declining-balance method of depreciation, the rate used is two times the percentage used in the straight-line method. • Based on geological surveys, management estimates that the ore body1 of the Xavier mine is approximately 15 million tonnes. DDM expects that it will extract an average of 1 million tonnes of ore from the gold mine annually, thus taking about 15 years to exhaust the ore body. Actual volume will change yearly based on the price of gold. It is not uncommon for the tonnage extracted from mines to be significantly different from that originally projected. • The senior vice president of extraction has suggested that DDM should adopt the straight-line method to depreciate the Jaw Crusher because he would like to extract the same volume of ore each year.
Required:
Brian, the company’s chief financial officer, has asked you, the financial controller and a CPA, to make recommendations with respect to an appropriate depreciation method for the brand-new class of equipment recently purchased by DDM for the Xavier mine.
Prepare a memo to Brian analyzing each of the three most widely used depreciation methods. Your memo should include a summary of pertinent information and do the following: • Identify and explain what each of the methods entails and then evaluate the advantages and disadvantages of each method. • Determine whether each of the three depreciation methods would be suitable and explain why or why not. • Recommend the estimated equipment life to be used; however, use management’s assumptions of a 15-year useful life when calculating depreciation expense. • Determine the estimated residual value to be used when calculating depreciation expense. • Recommend a depreciation method. Quantify the impact on DDM’s projected EBIT for each option under consideration.

Answer 1

Please upvote. Your upvote is extremely precious to me. Please upvote. Thank you so much. Please consider my efforts and request????‍♀️. Please Please

____________________________________________________________

Answer 1 :

Following are the 3 most commonly used methods of depreciation :-

1.Straight line method - This is perhaps the least complex strategy for depreciation where the asset is devalued with a similar incentive throughout the year. The rate is fixed and is charged on the estimation of assets.

For example , if machinery costs $100,000 and depreciation is charged @ 10% for 10 years with no salvage value then, the depreciation for all the 10 years will be -

$100,000 x 10% = $10,000

Advantages -

(a) Simplest method

(b) Assets can be written off completely

(c) Total depreciation charge is known

Disadvantages -

(a) Pressure on final years

(b) Interest lost

(c) Illogical method

2.Double declining method - Under this technique, the depreciation is charged on the successful expense of the hardware consistently. For instance, if hardware costs $100,000 today and is charged 10% depreciation for one year from now then the estimation of apparatus one year from now will become $90,000 and the depreciation for one year from now will be charged on it.

Advantages -

(a) Reduces tax obligations

(b) Matched maintenance cost

(c) Good Interest

Disadvantages -

(a) Depicts Poor Performance

(b) Low Dividend

(c) Complicated

3.Unit of production method - This method mostlt focuses more on usage of an asset rather than its useful life. It determines depreciation on basis of its over and remain workload.

Advantages -

(a) Shows the actual depreciation of an asset

(b) Cost and revenue are matched accurately

(c) Builds a relation between depreciation and asset.

Disadvantages -

(a) If assets produces nothing, then there will be no depreciation charged on it.

(b) Complex calculations

(c) Not applicable to all assets

Answer 2 :

Since there is no specific rate or the salvage value mentioned ,the straight line or the double declining method can not be used effectively. But the question clearly tells us about the solution that production and cost of Xavier mine. Hence , the units of production method would be the best to charge depreciation on mine.

Answer 3 :

15 years would be ideal charging depreciation on Jaw Crusher as it takes almost 15 years to exhaust body of gold and production of Jaw Crusher also decreases significantly after 15 years, hence 15 years assumption would remain work best for company.

Answer 4 :

Under straight line method,

Cost of Jaw Crusher = $10.5 millions

Useful life = 15 years

Estimated depreciation expense = 0.65 millions

Estimated residual value = Depreciation - (Useful life*Depreciation expense)

= $10.5 millions - [ 15 x 0.65 millions ]

= $0.75 millions

Answer 5 :

Units of production would be the best method to estimate the depreciation of Jaw Crusher as the asset continuously work till it's lifetime and hence it would be best to use that method. Whereas, using Straight line or Double declining method would involve assumptions of rate of depreciation and residual value which would make the depreciation inaccurate.

__________________________________________________________

Please upvote. Your upvote is extremely precious to me. Please upvote. Thank you so much. Please consider my efforts and request????‍♀️. Please Please