Assume that a loss in any year will result in a tax credit.
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You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index,
Mini Case
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 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 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 then mining is completed, the land must be restored to near its original condition. The land can 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
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 the 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
Bethesda will be responsible for reclaiming the land at the termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the company’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 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 $6million. Bethesda faces a 25 percent tax rate and has a 12 percent required return on new strip mine project. Assume that a loss in any year will result in a tax credit.
Net Present Value (NPV) is the difference between the present value of cash inflow and the present value of cash outflow. positive NPV represents the profitability of the project. When NPV is positive, we should accept the project and when NPV is negative, we should reject the project.
Internal Rate of Return (IRR) is the rate at which the present value of cash inflow is equal to the present value of cash outflows. It is the rate where NPV is zero. If IRR is greater than the cost of capital, we should accept the project and if IRR is less than the cost of capital, we should reject the project.
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