Problem 10-12 NPV and IRR Analysis After discovering a new gold vein in the Colo
ID: 2761035 • Letter: P
Question
Problem 10-12
NPV and IRR Analysis
After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to go ahead and develop the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that results in environmental damage. Before proceeding with the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its installation. The gold mined will net the firm an estimated $350,000 each year over the 5-year life of the vein. CTC's cost of capital is 13%. For the purposes of this problem, assume that the cash inflows occur at the end of the year.
What is the project's NPV? Round your answer to the nearest dollar.
$
What is the project's IRR? Round your answer to two decimal places.
%
Should this project be undertaken if environmental impacts were not a consideration?
-Select-YesNo
How should environmental effects be considered when evaluating this, or any other, project?
-Select-
I. Environmental effects should be treated as sunk costs.
II. Environmental effects could be added by estimating penalties or any other cash outflows that might be imposed on the firm to help return the land to its previous state (if possible).
III. Environmental effects should be ignored since they would have no effect on the project's profitability.
Explanation / Answer
a)
Cost of New Mining Equipment = $9,00,000
Cost of Installation of the Equipment = $1,65,000
Total Initial Investment = $9,00,000 + $1,65,000 = $10,65,000
Cost of Capital (r) = 13%
Year
Cash Flows
PVIF @ 13%
Present value
0
-$10,65,000
1.000
-$10,65,000
1
$3,50,000
0.885
$3,09,750
2
$3,50,000
0.783
$2,74,050
3
$3,50,000
0.693
$2,42,550
4
$3,50,000
0.613
$2,14,550
5
$3,50,000
0.543
$1,90,050
NPV = $1,65,950
Using the Financial Calculator we calculate IRR as:
IRR = $3,50,000 + [1-(1+R)-5]/R - $10,65,000 = 19.21%
b) Ignoring the environmental impacts the Project should be undertaken because NPV is positive and IRR is greater than the firm’s cost of capital. Overall the project is profitable.
c) The analysis ignores the environmental effects caused by mining process. Environmental effect is an example of an externality.The firm should deduct the cost of environmental effect from the expected cash flows to get a better estimate of the marginal benefits and marginal costs of the project. If the environmental costs were large enough, it might lead the manager to reject the project.
Year
Cash Flows
PVIF @ 13%
Present value
0
-$10,65,000
1.000
-$10,65,000
1
$3,50,000
0.885
$3,09,750
2
$3,50,000
0.783
$2,74,050
3
$3,50,000
0.693
$2,42,550
4
$3,50,000
0.613
$2,14,550
5
$3,50,000
0.543
$1,90,050
NPV = $1,65,950
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