QUESTION 3 (12 MARKS)

Deep Down Mining Corp. (DDM) is a publicly traded, Canadian-based mining operation

with various mines located throughout Canada. Investors benchmark earnings

compared to market expectations and to other similar companies.

DDM's loan facility with a consortium of banks stipulates that DDM's long-term debt

cannot exceed 1.5 times the book value of its equity. DDM is not currently in danger of

breaching this covenant, but is planning some acquisitions that will increase its debt

significantly and bring its debt-to-equity ratio much closer to the stipulated maximum.

Wherever feasible, DDM prefers to adopt accounting policies that increase short-term

profitability, to keep the equity base strong.

As part of its compensation package, DDM awards bonuses to its executives on an

annual basis. The primary criterion considered by the board of directors when

determining the size of the bonuses to be awarded to the executives overseeing the

production side of the mine is the firm's actual earnings before interest and taxes (EBIT)

compared to the budgeted EBIT for the year.

Projected financial results for the Xavier mine, an open-pit gold mine in northern British

Columbia, are shown below. However, projections are notoriously unreliable, because

the selling price of gold per ounce fluctuates significantly from year to year. When prices

are high, the mine increases production volume and when prices are low, production

volume is reduced. The results below are based on expected high price/high volume in

Year 2 and low price/low volume in Year 3, but the opposite situation might unfold, or

prices might be constant. Extraction costs are stable per tonne processed, and are

projected to increase by inflation only.