Question

2C- Windhoek Mines, Ltd., of Namibia, is contemplating the purchase of equipment to exploit a mineral deposit on land to which the company has mineral rights. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with opening and operating a mine in the area: 3+1= 4 marks) Cost of new equipment and timbers ... Working capital required ... Annual net cash receipts .. Cost to construct new roads in three years Salvage value of equipment in four years.. $275,000 $100,000 $120,000 $40,000 $65,000 "Receipts from sales of ore, less out-of-pocket costs for salaries, uties, insurance, and so forth. The mineral deposit would be exhausted after four years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company's required rate of return is 20%. Required: Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

Answer 1

Answer: The following are the details given.

a) Cost of new equipment and timbers = $275,000

b) Working Capital = $100,000

c) Annual net Cash receipts = $120,000

d) Cost of construction of new roads in 3 years = $40,000

e) Salvage value of equipment in 4 years = $65,000

f) Release of working capital after 4 years = $100,000

f) Required rate of return = 20%

Net Present Value (NPV)

A discounted cash flow measure to evaluate the viability of an investment proposal. It serves to determine whether the present value of estimated cash flow exceeds the investment on a project. The Net Present Value is the difference of the sum of discounted cash flows and the outlay.

NPV of cash flow = Present value of all future cash in flows over the life of the project (-) Present value of cash out flow

Now, other than Annual Cash receipts, discounting factor at 20% are as follows as per present value table:

Year - 3 = 0.579

Year - 4 = 0.482

Now, for Annual Cash receipts, cumulative discounting factor at 20% is as follows as per annuity table:

Year - 4 = 2.589

i) The Present value of cash out flows = $275,000 X 1 + $100,000 X 1 + $40,000 X 0.579 = $398,160

ii) The Present value of cash in flows = $100,000 (Release of working capital) X 0.482 + $65,000 X 0.482 + $120,000 X 2.589 = $390,210

iii) Hence, NPV = $390,210 (-) $398,160 = (-) $7,950

From the above it is clear that the net present value is negative. Hence, the project should not be accepted.