# Question

Harrington Explorations Inc. is interested in expanding its copper mining operations in Indonesia. The area has long been noted for its rich deposits of copper ore. With copper prices at near-record levels, the company is considering an investment of $ 60 million to open operations into a new vein of ore that was mapped by company geologists four years ago. The investment would be expensed (a combination of depreciation of capital equipment and depletion costs associated with using up the ore deposit) over five years toward a zero value. Because Harrington faces a corporate tax rate of 30%, the tax savings are significant.

The company’s geologists also estimate that the ore will be of about the same purity as existing deposits, meaning that it will cost $ 150 to mine and process a ton of ore containing roughly 15% pure copper. The company estimates that there are 75,000 tons of ore in the new vein that can be mined and processed over the next five years at a pace of 15,000 tons per year.

Harrington’s CFO asked one of his financial analysts to come up with an estimate of the expected value of the investment using the forward price curve for copper as a guide to the value of future copper production. The forward price curve for the price per ton of copper spanning the next five years when the proposed investment would be in production is as follows:

In a study commissioned by the CFO last year, the firm’s cost of capital was estimated to be 9.5%. The risk-free rate of interest on five-year Treasury bonds is currently 5.5%.

a. Estimate the after-tax (certainty-equivalent) project free cash flows for the project over its five-year productive life.

b. Using the certainty-equivalent valuation methodology, what is the NPV of the project?

c. Assume now that the analyst estimates the NPV of the project using the certainty-equivalent methodology and it is negative. When the firm’s CFO sees the results of the analysis, he suggests that something must be wrong because his own analysis using conventional methods ( i. e., expected cash flows and the firm’s weighted aver-age cost of capital) produces a positive NPV of more than $ 450,000. Specifically, he estimates that the price of copper for 2016 would indeed be $ 7,000 per ton but that this would increase by 12% per year over the five-year life of the project. How should the analyst respond to the CFO’s concerns?

The company’s geologists also estimate that the ore will be of about the same purity as existing deposits, meaning that it will cost $ 150 to mine and process a ton of ore containing roughly 15% pure copper. The company estimates that there are 75,000 tons of ore in the new vein that can be mined and processed over the next five years at a pace of 15,000 tons per year.

Harrington’s CFO asked one of his financial analysts to come up with an estimate of the expected value of the investment using the forward price curve for copper as a guide to the value of future copper production. The forward price curve for the price per ton of copper spanning the next five years when the proposed investment would be in production is as follows:

In a study commissioned by the CFO last year, the firm’s cost of capital was estimated to be 9.5%. The risk-free rate of interest on five-year Treasury bonds is currently 5.5%.

a. Estimate the after-tax (certainty-equivalent) project free cash flows for the project over its five-year productive life.

b. Using the certainty-equivalent valuation methodology, what is the NPV of the project?

c. Assume now that the analyst estimates the NPV of the project using the certainty-equivalent methodology and it is negative. When the firm’s CFO sees the results of the analysis, he suggests that something must be wrong because his own analysis using conventional methods ( i. e., expected cash flows and the firm’s weighted aver-age cost of capital) produces a positive NPV of more than $ 450,000. Specifically, he estimates that the price of copper for 2016 would indeed be $ 7,000 per ton but that this would increase by 12% per year over the five-year life of the project. How should the analyst respond to the CFO’s concerns?

## Answer to relevant Questions

Glentech Manufacturing is considering the purchase of an automated parts handler for the assembly and test area of its Phoenix, Arizona, plant. The handler will cost $ 250,000 to purchase plus $ 10,000 for installation. If ...Steve’s Sub Stop (Steve’s) is considering investing in toaster ovens for each of its 120 stores located in the southwestern United States. The high capacity conveyor toaster ovens, manufactured by Lincoln, will require ...A number of industrial products include gold and silver as a component because they have very good conductive properties. The S& M Smelting Company engages in the recovery of gold from such products and is considering a ...Newport Mining has a lease, with two years remaining, in which it can extract copper ore on a remote island in Indonesia. The company has completed the exploration phase and estimates that the mine contains 5 million pounds ...Reliable Industries is considering the construction of a power plant investment in India. Reliable’s analysts calculate that the cost of building the plant is $ 600 million, and the internal rate of return (IRR) of the ...Post your question

0