BETHESDA MINING COMPANY Bethesda Mining is a midsized coal mining company with 2
ID: 2638284 • Letter: B
Question
BETHESDA MINING COMPANY
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 just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric 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 $5 million. Based on a recent appraisal, the company feels it could receive $5.5 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 simply 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 purchased additional necessary equipment, which will cost $85 million. The equipment will be depreciated on a seven-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 year. 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 $82 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 $76 per ton. Variable costs amount to $31 per ton, and fixed costs are $4,100,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales.
Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the company
Explanation / Answer
Notes:
1) The resale value of land and the profit foregone for transferring the equipment has been considered as cash outflow and inflow respectively.
2) Net cash flow from the reclamation of land = -2.7 + tax advantage @38% = -2.7 + 1.026 =$ (1.674) Million
3) The tax advantage on expense allowance of $6 million has been considered as inflow for the 6th year
4) Payback period = 2 + (93.006 - 72.026) / (114.664 - 72.026) = 2.5 years (aaprox)
5) IRR = 0.12 + [(0 - 63.17)/(-2.92 - 63.17)] x (0.40 - 0.12) = 39% (approx)
Recommendation: The company should open the mine and accept the contract
year 0 1 2 3 4 5 6 Production (tons) 620000 680000 730000 590000 Quantity sold to Ohio Company (tons) 500000 500000 500000 500000 Quantity sold to spot market (tons) 120000 180000 230000 90000 Cash Flow Opprtunity cost of land -5.50 Cost of equipment -85 NWC @ 5% of sales for the next year 2.506 2.734 2.924 2.392 Sales (In Million $): To Ohio Company @$82 per ton 41.000 41.000 41.000 41.000 To the spot market @ 76 per ton 9.120 13.680 17.480 6.840 Variable cost @$31 per ton -19.220 -21.080 -22.630 -18.290 Fixed Cost -4.100 -4.100 -4.100 -4.100 depreciation -20.643 -15.630 -11.834 -8.960 Income Before Tax 6.157 13.870 19.916 16.490 Tax @ 38% -2.340 -5.271 -7.568 -6.266 Income After Tax 3.817 8.600 12.348 10.224 Add: Depreciation 20.640 15.630 11.834 8.960 Investment in NWC at the beginning of the year of sales -2.506 -0.228 -0.190 Recovery of working capital 0.532 2.392 Cost of reclamation -2.700 tax benefit of the cost of reclamation (2.7 * 0.38) 1.026 Tax benefit of expense allowance (6*0.38) 2.280 Notional after tax profit foregone by the company for the equipment 14.301 Net Cash Inflow/(Outflow) -93.006 36.710 49.243 59.902 64.983 -1.674 2.280 Discount Factor@12% 1.000 0.893 0.797 0.712 0.636 0.567 0.507 PV of cash flow -93.006 32.777 39.256 42.637 41.298 -0.950 1.155 Cumulative Cash Inflow 32.770 72.026 114.664 155.961 155.011 156.166 Calculation of book value of The equipment after 4 years Cost of the equipment 85.000 less depreciation for 4 years -57.066 Book Value of the machine at the end of the 4th year 27.934 Resale value at the end of the 4th year 51 Notional Profit Foregone by the company 23.066 Tax on profit @38% 8.765 After Tax Profit 14.301 NPV 63.167 PI (PV of Inflow/PV of Outflow) 1.679 Payback Period 2.492 years Calculation of IRR Discount Rate NPV 12% 63.17 r% 0.00 40% -2.92 IRR of the project 39% approxRelated Questions
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