Question

BETHESDA MINING COMPANY Bethesda Mining is a midsized coal raining company with 20 mines located in Ohio, Pennsyl- vania, 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 com- pany'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 reclama- tion 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.

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

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

NPV = $10,692,628

IRR is calculated using IRR function in Excel

IRR = 15.98%

PI = (NPV + year 0 cash outflow) / year 0 cash outflow

PI = 1.10

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 3 + (cash flow required in year 4 for cumulative cash flows to equal zero / year 4 cash flow) = 3 + ($19,697,375 / $76,287,375) = 3.26 years

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.

А B C D E F G H 1 0 1 2 3 4 5 6 $95,000,000 $6,500,000 620,000 500,000 120,000 $52,240,000 $19,220,000 $4,100,000 $13,575,500 $15,344,500 $3,836,125 $11,508,375 $13,575,500 $2,612,000 $2,843,000 $2,612,000 $231,000 ($2,612,000) $24,852,875 680,000 730,000 590,000 500,000 500,000 500,000 180,000 230,000 90,000 $56,860,000 $60,710,000 $49,930,000 $21,080,000 $22,630,000 $18,290,000 $4,100,000 $4,100,000 $4,100,000 $23,265,500 $16,615,500 $11,865,500 $8,414,500 $17,364,500 $15,674,500 $2,103,625 $4,341,125 $3,918,625 $6,310,875 $13,023,375 $11,755,875 $23,265,500 $16,615,500 $11,865,500 $3,035,500 $2,496,500 $O $192,500 ($539,000) ($2,496,500) $29,383,875 $30,177,875 $26,117,875 2 Initial Investment 3 Cost of equipment 4 Land 5 6 OCF 7 Sales in tons - total 8 Sales in tons - contract 9 Sales in tons - spot market 10 Revenues 11 - Variable costs 12 - Fixed Costs 13 - Depreciation 14 EBIT 15 - Taxes 16 Income after tax 17 + Depreciation 18 NWC required 19 Change in NWC 20 OCF 21 22 Terminal Cash Flow 23 Salvage Value 24 Accumulated depreciation 25 Book value of equipment 26 Profit on sale of equipment 27 Tax 28 Salvage Value after tax 29 Reclamation 30 Charitable expense - tax benefit 31 32 NPV Analysis 33 Project Cash Flows 34 Cumulative Cash Flows 35 Discounted Cash Flows 36 NPV 37 IRR 38 PI 39 Payback period 40 $57,000,000 $65,322,000 $29,678,000 $27,322,000 $6,830,500 $50,169,500 $2,700,000 $1,500,000 ($104,112,000) $24,852,875 $29,383,875 $30,177,875 $76,287,375 ($2,700,000) $1,500,000 ($104,112,000) ($79,259,125) ($49,875,250) ($19,697,375) $56,590,000 $53,890,000 $55,390,000 ($104,112,000) $22,190,067 $23,424,645 $21,480,015 $48,482,006 ($1,532,053) $759,947 $10,692,628 15.98% 1.10 3.26

B C D E F H 0 1 2 3 4 5 6 95000000 6500000 А 1 2 Initial Investment 3 Cost of equipment 4 Land 5 6 OCF 7 Sales in tons - total 8 Sales in tons - contract 9 Sales in tons - spot market 10 Revenues 11 - Variable Costs 12 - Fixed Costs 13 - Depreciation 14 EBIT 15 - Taxes 16 Income after tax 17 + Depreciation 18 NWC required 19 Change in NWC 20 OCF 21 22 Terminal Cash Flow 23 Salvage Value 24 Accumulated depreciation 25 Book value of equipment 26 Profit on sale of equipment 27 Tax 28 Salvage Value after tax 29 Reclamation 30 Charitable expense - tax benefit 31 32 NPV Analysis 33 Project Cash Flows 34 Cumulative Cash Flows 35 Discounted Cash Flows 36 NPV 37 IRR 38 PI 39 Payback period 20 620000 680000 730000 590000 500000 500000 500000 500000 =C7-C8 =D7-08 =E7-E8 =F7-F8 =(C8*86)+(C9*77) = (D8*86)+(D9*77) =(E8*86)+(E9*77) =(F8*86)+(F9*77) =C7*31 =D7*31 =E7*31 =F7*31 4100000 4100000 4100000 4100000 =$B$3*14.29% =$B$3*24.49% =$B$3*17.49% =$B$3*12.49% =C10-C11-C12-C13 =D10-D11-D12-D13 =E10-E11-E12-E13 =F10-F11-F12-F13 =C14*25% D14*25% =E14*25% =F14*25% C14-C15 =D14-D15 =E14-E15 =F14-F15 =C13 =D13 =E13 =F13 =D10*5% =E10*5% =F10*5% =G10*5% =C18-B18 =D18-C18 =E18-D18 =F18-E18 =C16+C17-C19 =D16+017-019 =E16+E17-E19 =F16+F17-F19 =C10*5% =B18 =B16+B17-819 =B3*60% =SUM(C13:F13) =B3-F24 =F23-F25 =F26*25% =F23-F27 2700000 =6000000*25% =C20 =D20 =E20 =F20+F28 --G29 =H30 =C33+B34 =D33+C34 =E33+D34 =F33+E34 =G33+F34 =H33+G34 =C33/(1+12%)“C1 =D33/(1+12%)^D1=E33/(1+12%)^E1 =F33/(1+12%)^F1 =G33/(1+12%)^G1 =H33/(1+12%)^H1 --B3-B4+B20 =B33 =B33/(1+12%)^B1 =SUM(B35:H35) =IRR(B33:H33) = (B36+(-B33))/(-833) =3+(-E34/F33)