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Recent increases in gold prices have prompted TomKat Goldfields, Inc. to consider reopening an inactive mine.  Last...

Recent increases in gold prices have prompted TomKat Goldfields, Inc. to consider reopening an inactive mine.  Last year, TomKat paid a team of geologists $200,000 to assess the amount of recoverable gold at the mine.  The geologists estimated that 45,000 troy ounces of gold could still be recovered from the mine.   The price of gold is now $800 per ounce, and hedge contracts can be used to lock in this price for up to five years.  Direct excavation costs would be $5.2 million per year for five years.   These expenditures would allow recovery of 5,000 ounces of gold the first year, and 10,000 ounces in each of the second through fifth years.  New mining equipment with a cost of $8 million would be needed right away. The equipment could be depreciated according to the five year MACRS schedule, and would be sold at the end of year 5 for an estimated salvage value of $1.2 million.  The tax rate is 21%.

The geologists’ report noted that TomKat has sufficient furnace capacity at its platinum plant, as Tomkat’s platinum division uses only 60% of the furnace capacity.   Currently, that excess capacity is used to process ore for Bre-Y Mining Inc., in exchange for a payment of $800,000 per year.  The out-of-pocket cost of running the furnaces (which would be unchanged in any case) is $1.4 million per year, and processing the gold from Tomkat’s mine would require 40% of the furnace capacity. The discount rate is 10% per year.  You can assume that TomKat has several million dollars of taxable income from other profitable operations. (a) Forecast the incremental cash flows to TomKat that would result from reopening the mine, on a year-by-year basis. (b) Compute the NPV and the IRR of the proposal to reopen the gold mine at this point in time.

Solutions

Expert Solution

a) INCREMENTAL CASH FLOWS: 0 1 2 3 4 5
Gold recovery in ounces $              5,000 $                10,000 $                10,000 $                     10,000 $                     10,000
Sales at $800/ounce $      40,00,000 $          80,00,000 $          80,00,000 $               80,00,000 $               80,00,000
Direct excavation costs $      52,00,000 $          52,00,000 $          52,00,000 $               52,00,000 $               52,00,000
Depreciation [MACRS 5 YEAR] $      16,00,000 $          25,60,000 $          15,36,000 $                 9,21,600 $                 9,21,600 460800 8000000
[8000000*0.2] [8000000*0.32] [8000000*0.192] [8000000*0.1152] [8000000*0.1152] [8000000*0.0576]
Loss of revenue from Bre-Y Mining $        8,00,000 $             8,00,000 $             8,00,000 $                 8,00,000 $                 8,00,000
NOI (Sales-Direct excavation costs-Depreciation-Loss of revenue from Bre-Y Mining) $    -36,00,000 $           -5,60,000 $             4,64,000 $               10,78,400 $               10,78,400
Less: Tax at 21% [NOI*21%] $      -7,56,000 $           -1,17,600 $                97,440 $                 2,26,464 $                 2,26,464
NOPAT $    -28,44,000 $           -4,42,400 $             3,66,560 $                 8,51,936 $                 8,51,936
Add: Depreciation $      16,00,000 $          25,60,000 $          15,36,000 $                 9,21,600 $                 9,21,600
OCF $    -12,44,000 $          21,17,600 $          19,02,560 $               17,73,536 $               17,73,536
Capital expenditure $     80,00,000
Salvage value $               12,00,000
Tax on gain = (1200000-460800)*21% = $                 1,55,232
Incremental cash flows [OCF-Capital expenditure-+Salvage value-Tax on gain] $    -80,00,000 $    -12,44,000 $          21,17,600 $          19,02,560 $               17,73,536 $               28,18,304
b) PVIF at 10% [PVIF = 1/1.1^n] 1 0.90909 0.82645 0.75131 0.68301 0.62092
PV at 10% [Incremental cash flows*PVIF] $    -80,00,000 $    -11,30,909 $          17,50,083 $          14,29,421 $               12,11,349 $               17,49,945
NPV (Sum of PV's of Years 0 to 5] $    -29,90,111
IRR:
IRR is that discount rate for which NPV is 0. It has to be found out by trial and error to get 0 NPV.
IRR would be negative as the undiscounted cash inflows total to $      73,68,000 which is less
than the iniital investment of $8,000,000.
DECISION:
As the NPV is negative, the project is not viable.

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