Question

Bethesda Mining is a mid-sized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip minds. 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 after-tax 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 4 years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60% of its initial purchase price in four years. 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% 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 minds. 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% tax rate and has a 12% 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 NPV, IRR for the new strip mine. Should Bethesda Mining take the contract and open the mine?

Answer 1

Given,

Value of land is $6,500,000.

Equipment cost is $95,000,000.

Equipment life is 7 years.

Equipment’s salvage value is 60% after 4 year.

Coal per ton rate is $86.

Required coal for contract is $500,000 ton.

Sale of excess production is $77 per ton.

Variable cost is $31.

Fixed cost is $4,100,000.

Net working capital investment is 5% of the sales.

Rate of tax is 25%.

Rate of discount is 12%.

Time 0 Cash flow
Equipment	-95000000
Land	-6500000
NWC	-2612000
Total	-104112000
Sales	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Contract	43000000	43000000	43000000	43000000	43000000	43000000
Spot	9240000	13860000	17710000	6930000
Total Sales	52240000	56860000	60710000	49930000
VC	19220000	21080000	22630000	18290000
FC	4100000	4100000	4100000	4100000	2700000
Dep	13575500	23265500	16615500	11865500
EBT	15344500	8414500	17364500	15674500	-2700000
Tax	3836125	2103625	4341125	3918625	-675000	-1500000
NI	11508375	6310875	13023375	11755875	-2025000	1500000
OCF	25083875	29576375	29638875	23621375	-2025000	1500000
Begg NWC	2612000	2843000	3035500	2496500
Ending NWC	2843000	3035500	2496500
NWC Cash Flow	-231000	-192500	539000	2496500
Total Cash Flow	24852875	29383875	30177875	26117875	-2025000	1500000
Book Value	81424500	58159000	41543500	29678000
Salvage	MV	57000000		Time	Cash Flow
	BV	29678000		0	-104112000
	Taxes	-6830500		1	24852875
Salvage CF		50169500		2	29383875
				3	30177875
				4	76287375
NPV	1,10,75,640.82			5	-2025000
IRR	16.11%			6	1500000
IRR	16.11%

Since the NPV of the project is positive, the company should take the contract and open the mine.

Enclosed herewith is the reference for workings base.

1 Time 0 cash flow 2 Equipment 3 Land 4 NWC 5 Total In (S) -95000000 -6500000 -2612000 =B2+B3+B4 Year 6 -86*500000 Sales 8 Contract 9 Spot 10 Total Sales 11 VC 12 FC Year 1 -86*500000 =77*(620000-500000) =B8+B9 =31*620000 4100000 -14.29% 95000000 -B10-B11-B12-B13 =B14*38% =B14-B15 -B16+B13 --B4 =5%*C10 =B18-B19 =B17+B20 =95000000-B13 13 Dep 14 EBT 15 TAX 16 NI 17 OCF 18 Beginning NWC 19 Ending NWC 20 NWC cash flow 21 Total cash flow 22 Book value Year 2 Year 3 Year 4 Year 5 =86500000 -86*500000 =86500000 =86*500000 =77*(680000-500000) =77*(730000-500000) =77*(590000-500000) =C8+C9 =D8+D9 =E8+E9 =31*680000 =31.730000 =590000 31 4100000 4100000 4100000 2700000 -24.49%95000000 -17.49% 95000000 -12.49%95000000 -C10-C11-C12-C13 =D10-D11-D12-D13 E10-E11-E12-E13 -2700000 =C1438% | D14*38% =E1438% =F14*38% TC14 C15. =D14-D15 =E14-E15 =F14-F15 -C16+C13 -D16+013 =E16+E13 =F16+F13 -B19 -C19 -D19 = 5%D10 -5%E10 =C18-C19 =D18-D19 =E18-E19 =C17+C20 =D17+D20 =E17+E20 =B22-C13 =C22-D13 =D22-E13 =-600000038% =G14-G15 -G16+G13 24 Salvage Time MV BV -0.6*-(B2) =E22 =(C24-C25)*-38% =C24+C26 Taxes 27 Salvage CF Cash Now =B5 =B21 -C21 -D21 -E21+27 =F17 =G17 28 29 NPV 30 IRR 31 IRR =NPV(12%,F26:F31)+F25 =IRR(F25:F31) =IRR(F25:F31.-0.99)