Question

Geo Excavators Ltd (GEL) is a large mining company that specialises in metals and minerals.
GEL has 10 million shares originally issued at $100 and 2 million 5% semi-annual bonds issued
at face value of $1000 outstanding. The bonds have 15 years to maturity and are currently
selling at par. The common stock currently trades at $300 per share.
The current beta of the company is estimated to be 1.5. The expected return on the market is
10.5 per cent. The relevant T-Bills are yielding 3 per cent. The applicable corporate tax rate is
30 per cent.
GEL is currently in the process of applying for a tender offer for one of the newly discovered
mines for Gems and other precious stones. The acronym for this project is GPS. GPS is a part
of the expansion and diversification strategy of GEL.
The geoscientists at GEL spent $500,000 to gather particulars about the mine. Their report
forms the basis of the analysis. The acquisition cost is estimated to be $73 million. The setup
required for extraction and refining of these stones is estimated to be $7 million. GEL also
requires replacing some of its existing excavators. The new excavators will cost $3 million,
and the old ones, which are already fully depreciated, shall be sold at $2 million. The additional
working capital required would be $1 million.
The estimated life of the mine is five years. At the end of 5 years, the mine along with the
existing setup and excavators shall be sold for $25 million. The depreciation on the mine, setup
and excavators is to be charged on straight line method, and the values are to be written down
to nil during this period.
The expected sales revenue from finished stones is $30 million each year. The variable
operating cost is 30% of the sales revenue. GEL intends to use management personnel,
employees and labour from another project. Consequently, the progress of the other project
gets affected. The estimated cash flow impact of undertaking GPS to the other project is $1
million per year. The finished products from GPS shall be stored in the existing secured
warehouse already costing $500,000 a year to GEL as fixed cost.
Finally, the capital structure and risk for the investments in GPS remain the same as for GEL.
Required:
(a) Evaluate the project and advise if GEL should invest in this project. Show all
working/detailed steps that lead to the final answers.
(b) Suppose GPS is financed only by equity. In this case, what discount rate should GEL use
to evaluate GPS? Will that revise the decision made in part (a)? Show all workings.

Answer 1