Green Coal 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 Green Coal, has been

hard$-$hit by environmental regulations. Recently, however, a combination of increased demand for

coal and new pollution reduction technologies has led to improved market demand for high$-$sulfur

coal. Green Coal has just been approached by Mid$-$Ohio Electric Company with a request to supply

coal for its electric generators for the next four years. Green Coal 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. Green Coal will need to purchase the land, which will

cost $$5$ million. The land cannot be depreciated for tax purposes and will be worthless at the end

of the contract $($i$.$e$.,$ a market value of zero$).$

In addition, Green Coal is currently operating at full capacity. Green Coal will also need to

purchase additional necessary equipment, which will cost $$64$ million. The equipment will be

depreciated on a four$-$year straight$-$line schedule. The contract runs for only four years. At that

time, the coal from the site will be entirely mined. The company estimates that the equipment will

be worthless at the end of the contract $($i$.$e$.,$ a market salvage value of zero$).$

The contract calls for the delivery of $500,000$ tons of coal per year at a price of $$80$ per ton. Green

Coal Mining feels that coal production will be $600,000$ tons, $700,000$ tons, $800,000$ tons, and

$500,000$ tons, respectively, over the next four years. The excess production will be sold in the spot

market at an average of $$70$ per ton. Variable costs amount to $$30$ per ton, and fixed costs are

$$4,000,000$ per year. The mine will require a net working capital $($NWC$)$ investment. Based on the

company$$s experience, NWC is estimated based on $5\%$ of next year$$s sales.

Strip mining is a process where the layers of topsoil 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. Green Coal 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 the reclamation of all the

company$$s strip mines. It is estimated the cost of reclamation will be $$2\mathrm{.}5$ million. This expense

is tax deductible.

Green Coal faces a $28$ percent tax rate and has a $12\mathrm{.}5$ percent required return on new strip mine

projects. Assume that a loss in any year will result in a tax credit, as the company overall is

profitable.

You have been approached by the president of the company with a request to analyze the project.

Calculate the net present value $($NPV$)$ and internal rate of return $($IRR$)$ for the new strip mine. The

company is not sure about the cost of capital estimates and would like you to include a sensitivity

analysis based on a potential error of $1\%.$

Notes for solution:

$1.$ Project termination in year $5$:

Although the production ends at the end of year $4,$ you will need to take into account the

year$-5$ reclamation cost when calculating the NPV and IRR. Assume that the firm is

profitable so this expense is tax deductable.

$2.$ Net working capital calculation:

Net working capital is $5\%$ of next year$$s sales. That means that in year $4,$ NWC is closed

since there are zero sales in year $5.$

$3.$ Sensitivity analysis:

Include NPV calculations based on a cost of capital of $11\mathrm{.}5\%$ and $13\mathrm{.}5\%.$

$4.$ Points allocation:

a$.$ Sales $20$ points

b$.$ Costs $30$ points

c$.$ Cash flow adjustments $30$ points

d$.$ NPV and leaseIRR $20$ points

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