A large mining company is planning a major new development. To provide funds and to permit management to concentrate on the new development, the company would like to sell an operating underground copper mine with remaining reserves capable of supporting only four years of production. They are prepared to sell the mine for A$25 million.

Omega Mining is considering the purchase of the mine. They have carried out a due diligence investigation of the property and have decided that the following data are reliable within acceptable limits.

Reserves, 8 million tonnes to be mined and milled at the rate of 2 million tonnes per year.

The accepted mining schedule indicates that reserves grade will reduce over the 4 years, averaging 3.2% copper in year 1, 3.1% copper in year 2, and 3.0% copper in year 3 and year 4.

Metallurgical recovery will average 94% throughout.

Underground mining costs will average A$32/tonne in year 1 and will increase with expected inflation of 2.5%, year on year, for years 2, 3 and 4.

Milling and site administration costs will average A$18/tonne in year 1 and will increase with inflation as do mining costs.

Corporate overhead costs, including copper price hedging costs, will amount to A$2 million in year 1 and to A$500,000 in years 2, 3 and 4. These corporate overhead costs have been estimated in dollars of the year in which they are incurred.

Close down, rehabilitation, and redundancy costs, net of salvage value, will be incurred in the year after mining ceases. These costs are estimated to amount to A$18 million in dollars of the year in which they occur.

The existing concentrate sales agreements can be continued and forward sales can be arranged to guarantee an average price of US$4000/tonne of refined copper in year 1 and US$3000/tonne of refined copper in year 2 and a price of US$2400/tonne of refined copper in years 3 and 4. Refined copper prices are in dollars of the year in which they are received.

Realization costs reduce mine revenue to 55% of the refined copper price per tonne of recovered copper in concentrates.

Government royalties amount to 2.5% of my revenue.

The A$/US$ exchange rate is expected to average A$1 = US$0.78 in year 1, A$1 = US$0.74 in year 2, and A$1 = US$0.70 in years 3 and 4, reflecting an expected drop in commodity prices during that period.

The mine would be acquired as an operating mine, complete with existing equipment, stores, and consumables. However, the new owners would have to fund the operation for about 3 months before their first sales revenues would be received, amounting to about A$25 million

of working capital including A$1 million of hedging and corporate costs. The funding required for the purchase would thus amount to A$50 million. No sustaining capital would be required over the 4 years life of mining.

Omega operates on a 40:60 debt: equity ratio. It can fund A$30 million from its own resources and can borrow A$20 million at an interest rate of 10%. The A$20 million of debt will be repaid in equal payments in years 1 and 2 of my life. Omega believes its cost of equity capital is 15% and will use the weighted average cost of capital, rounded up to the next whole number, as the discount rate to evaluate the purchase.

The purchase price can be depreciated on a straight-line basis over the 4 years. the income tax rate is assumed to be 30% over the life of the operation.

YOUR task

1. Carry out discounted cash flow evaluation and determine the NPV and IRR of the value of the purchase and make recommendations.
2. Use the financial model to carry out a sensitivity analysis of the project to identify and rank the critical parameter

Answer rating: 100% (QA)

1 Assuming a 15 cost of equity the weighted average cost of capital wo... View the full answer