Beaver Mining is a mid-sized coal-mining company with 20 mines located in western Canada. 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-sulphur coal operations such as Beaver, 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-sulphur coal. Beaver has just been approached by the Mid-Western Electric Company with a request to supply coal for its electric generators for the next four years. Beaver Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in British Columbia on 2,000 hectares 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 after-tax basis if it sold the land today.
Strip mining is a process where the layers of top-soil 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, Beaver will need to purchase additional necessary equipment, which will cost $85 million. The equipment is in class 9 for CCA purposes (see Appendix 8A) and will thus depreciate at 25 percent per year. The equipment will be the only asset in the company’s CCA class. The equipment will be worthless at the end of seven years. 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. However, Beaver plans to open another strip mine at that time and will use the equipment at the new mine. For planning purposes, you believe that assets will remain in the CCA’s equipment class regardless of when the equipment is disposed of.
The contract calls for the delivery of 500,000 tonnes of coal per year at a price of $82 per tonne. Beaver Mining feels that coal production will be 620,000 tonnes, 680,000 tonnes, 730,000 tonnes, and 590,000 tonnes, respectively, over the next four years. The excess production will be sold in the spot market at an average of $76 per tonne. Variable costs amount to $31 per tonne, and fixed costs are $4,100,000 per year. The mine will require a net working capital investment of 5 percent of sales. The net working capital will be built up in the year prior to the sales.
Beaver 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 of the company’s strip mines. It is estimated the cost of reclamation will be $2.7 million. After the land is reclaimed, the company plans to donate the land to the province 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. Beaver faces a 38 percent tax rate and has a 12 percent 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 for the new strip mine. Should Beaver Mining take the contract and open the mine?