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    Net present value

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    Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous area. The tract contains a mineral deposit that the company believes might be commercially attractive to mine and sell. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with opening and operating a mine in the area:

    Cost of equipment required: $850,000
    Net annual cash receipts: $230,000*
    Working capital required: $100,000
    Cost of road repairs in 3 years: $60,000
    Salvage value of equipment in five years: $200,000
    *Receipts from sales of ore, less out-of-pocket costs for
    salaries, utilities, insurance, and so forth.

    It is estimated that the mineral deposit would be exhausted after five years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company's required rate of return is 14%.

    (Ignore income taxes.) Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

    Please show step by step calculations

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    Solution Summary

    Renfree Mines Inc

    Year Description Cash flow Discount factor @14% Discounted cash flow
    0 Cost of equipment $(850,000) 1.000 $(850,000)
    0 Working capital $(100,000) 1.000 $(100,000)
    1 Net annual cash receipts $230,000 0.877 $201,754
    2 Net annual cash receipts $230,000 0.769 $176,978
    3 Net annual cash receipts $230,000 0.675 $155,243
    3 Road repairs $(60,000) 0.675 $(40,498)
    4 Net annual cash receipts $230,000 0.592 $136,178
    5 Net annual cash receipts $230,000 0.519 $119,455
    5 Salvage value of the equipment $200,000 0.519 $103,874
    5 Recovery of working capital $100,000 0.519 $51,937
    Net present value $(45,079)

    Since the net present value of the project is negative, the project
    must not be accepted.

    The NPV is calculated by arriving at the present value of cash flows
    associated with the project at the company's required rate of return