On January 2, 2021, an Australian Copper Exploration Company was investigating the feasibility of two mutually exclusive investment projects. The first prospective investment involved a strip (open-cut) mining operation in South Wales. The second investment also involved the extraction of copper, but this expenditure would be an underground site in Queensland. Preliminary drilling, sampling and analysis of both sites and consultation with geologists, costing the company $3600,000, suggested that both sites have similar copper reserves and useful lives. The copper extraction process for the two types of mines and the equipment required for operation of the mines are very different, however, with the underground mining operation expected to be more complex and difficult. The process of drilling underground also increases the dangers faced by employees, although it is more environmentally friendly than the pollution and soil erosion caused by open-cut mining operations. For the past several months, Jonathan Smith has been involved in the development of revenue and expense projections for the two projects. For his analysis, necessary data exists from prior investments to provide relatively accurate cost data. After examining the data at hand, Smith made the following projections related to the investment costs for each project: Strip Mining Underground Mining Equipment $1,750,000 $2,000,000 Additional working capital requirements 200,000 200,000 Total $1,950,000 $2,200,000 With respect to these figures, experience suggests that a 10-year life may be expected on either of the two prospective investments, with the practice being to depreciate the equipment the MACRS over the life of the projects. Year 10-Year MACRS 1 10.00% 2 18.00% 3 14.40% 4 11.52% 5 9.22% 6 7.37% 7 6.55% 8 6.55% 9 6.55% 10 6.55% 11 3.28% Both sites have no alternative productive use for the company. The projected salvage value for the strip-mining operation would be $150,000 at project end, while the equipment for the underground plant could be expected to have a residual value of $600,000. The working capital requirement would arise at the time of the investment but could be released upon the termination of the project with only a negligible chance of the full amount not being recovered. In addition to the cost estimates, the engineers, based upon studies of the subsurface formations, were able to make projections as to the revenues that could be generated from the two fields. As a result of their studies, expected earnings before taxes for the two investments would be as follows: Years Annual expected earnings before taxes Strip mining 1–4 $468,000 5–7 $299,000 8–10 $169,000 Underground mining 1–4 $520,000 5–7 $286,000 8–10 $130,000 Upon receiving this information, Jonathan Smith questioned the reliability of the anticipated earnings. In response, Benjamin Brown, head of the engineering staff at the Australian Copper Exploration Company, informed him that both projects would have to be considered to be riskier than the firm’s typical investment. The analysis indicated that the expected cash flows from the underground mining operation were subject to considerably more uncertainty than those from the strip-mining project. In fact, Brown considered the extraction of coal through the underground facility to be twice as risky as that of the strip-mining alternative. For this reason, he recommended that the strip-mining project be discounted using a cost of capital of 10 percent rate, while the underground mining proposal be analysed with a 14 percent criterion. Smith questioned Brown’s logic, in that the company’s cost of capital had been computed to be 8 percent. He believed that this figure better reflected the shareholders’ required rate of return and for that reason should be used as the discount rate for both projects. The company’s marginal corporate tax rate is 20 percent on earnings and other cash flows. Questions: Which discount rate would you use in the estimation of the project’s NPV and why? Who is correct, Smith or Brown and why?
On January 2, 2021, an Australian Copper Exploration Company was investigating the feasibility of two mutually exclusive investment projects. The first prospective investment involved a strip (open-cut) mining operation in South Wales. The second investment also involved the extraction of copper, but this expenditure would be an underground site in Queensland. Preliminary drilling, sampling and analysis of both sites and consultation with geologists, costing the company $3600,000, suggested that both sites have similar copper reserves and useful lives.
The copper extraction process for the two types of mines and the equipment required for operation of the mines are very different, however, with the underground mining operation expected to be more complex and difficult. The process of drilling underground also increases the dangers faced by employees, although it is more environmentally friendly than the pollution and soil erosion caused by open-cut mining operations.
For the past several months, Jonathan Smith has been involved in the development of revenue and expense projections for the two projects. For his analysis, necessary data exists from prior investments to provide relatively accurate cost data. After examining the data at hand, Smith made the following projections related to the investment costs for each project:
|
|
Strip Mining |
Underground Mining |
|
Equipment |
$1,750,000 |
$2,000,000 |
|
Additional working capital requirements |
200,000 |
200,000 |
|
Total |
$1,950,000 |
$2,200,000 |
With respect to these figures, experience suggests that a 10-year life may be expected on either of the two prospective investments, with the practice being to depreciate the equipment the MACRS over the life of the projects.
|
Year |
10-Year MACRS |
|
1 |
10.00% |
|
2 |
18.00% |
|
3 |
14.40% |
|
4 |
11.52% |
|
5 |
9.22% |
|
6 |
7.37% |
|
7 |
6.55% |
|
8 |
6.55% |
|
9 |
6.55% |
|
10 |
6.55% |
|
11 |
3.28% |
Both sites have no alternative productive use for the company. The projected salvage value for the strip-mining operation would be $150,000 at project end, while the equipment for the underground plant could be expected to have a residual value of $600,000. The working capital requirement would arise at the time of the investment but could be released upon the termination of the project with only a negligible chance of the full amount not being recovered.
In addition to the cost estimates, the engineers, based upon studies of the subsurface formations, were able to make projections as to the revenues that could be generated from the two fields. As a result of their studies, expected earnings before taxes for the two investments would be as follows:
|
|
Years |
Annual expected earnings before taxes |
|
Strip mining |
1–4 |
$468,000 |
|
5–7 |
$299,000 |
|
|
8–10 |
$169,000 |
|
|
Underground mining |
1–4 |
$520,000 |
|
5–7 |
$286,000 |
|
|
8–10 |
$130,000 |
Upon receiving this information, Jonathan Smith questioned the reliability of the anticipated earnings. In response, Benjamin Brown, head of the engineering staff at the Australian Copper Exploration Company, informed him that both projects would have to be considered to be riskier than the firm’s typical investment. The analysis indicated that the expected cash flows from the underground mining operation were subject to considerably more uncertainty than those from the strip-mining project. In fact, Brown considered the extraction of coal through the underground facility to be twice as risky as that of the strip-mining alternative. For this reason, he recommended that the strip-mining project be discounted using a cost of capital of 10 percent rate, while the underground mining proposal be analysed with a 14 percent criterion. Smith questioned Brown’s logic, in that the company’s cost of capital had been computed to be 8 percent. He believed that this figure better reflected the shareholders’ required
Questions:
- Which discount rate would you use in the estimation of the project’s NPV and why? Who is correct, Smith or Brown and why?
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