Question

A forecasted increase in market prices has encouraged a multinational mineral resource company to consider the expansion of its project annual operating capacity and the reduction of its life span (i.e., mine faster the limited ore reserve). For this purpose, the following alternative after-tax cash flow estimates have been calculated by the engineering department of the company for the two choices:

 Existing production capacity (i.e., current choice): positive cash flows of $12.5 million per year over the remaining 10-year life.

 Expanded production capacity (i.e., potential alternative choice): spend $21.5 million for capital expenditure investment now (time 0), followed by positive annual cash flows of $20 million over the remaining 8-year life.

(i) Determine the distribution of cash flows for a) the existing; b) the expanded capacity choices, and c) the cash flow of the incremental expansion. Determine the rate of return (IRR) associated with the incremental expansion investment.

(ii) If the company’s cost of capital (i.e., rate to borrow money) is 10% and it is considering selling the particular operation, what should its minimum acceptable selling price be (choose between the existing or the expanded capacity choices)? Outline clearly your rationale in your recommendation to management.

Answer 1