Question

Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip
mines. Most of the coal mined is sold under contract, with excess production sold on the spot market.
The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of
increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has been approached by Mid-Ohio
Electric Company with a request to supply coal for its electric generators for the next 4 years. Bethesda Mining does not have enough excess capacity at its existing mines to
guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $4 million. Based on a recent appraisal, the
company feels it could receive $6.5 million on an aftertax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would remove the coal and
leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to
near its original condition. The land can then be used for other purposes. Because it is currently operating at full capacity, Bethesda will need to purchase additional necessary
equipment, which will cost $95 million. The equipment will be depreciated on a 7-year MACRS schedule. The contract runs for only four years. At that time the coal from the site
will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price in four years. However, Bethesda plans to open another strip
mine at that time and will use the equipment at the new mine.
The contract calls for the delivery of 500,000 tons of coal per year at a price of $86 per ton. Bethesda Mining feels that coal production will be 620,000 tons, 680,000 tons,
730,000 tons, and 590,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $77 per ton. Variable costs amount to
$31 per ton, and fixed costs are $4,100,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the
sales.
Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the
company’s strip mines. It is estimated the cost of reclamation will be $2.7 million. In order to get the necessary permits for the strip mine, the company agreed to donate the land
after reclamation to the state for use as a public park and recreation area. This will occur in Year 6 and result in a charitable expense deduction of $6 million. Bethesda faces a 25
percent tax rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit.
You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index, net present value, and
internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?

Answer 1

The $4 million cost of the land 10 years ago is a sunk cost and irrelevant. The $6.5 million after-tax sale price of the land today is an opportunity cost and is relevant.

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital

profit on sale of equipment at end of year 4 = sale price - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment

Tax benefit in year 6 = charitable expense deduction * tax rate

Profitability index = (NPV + initial investment) / initial investment

Payback period = last in year in which cumulative cash flow is negative + (cash flow required in next year to make cumulative cash flows equal zero / next year cash flow)

NPV = sum of present values of cash flows

present value of each cash flow = cash flow / (1 + required return)ⁿ

where n = number of years after which the cash flow occurs

IRR is calculated using IRR function in Excel

NPV is $10,692,628

IRR is 15.98%

Yes, Bethesda Mining should take the contract because the NPV is positive and the IRR is higher than the required return.

The calculations are below :