Bethesda Mining is a mid sized 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 Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda 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. The land needed for this strip mine may be purchased for $5 million.
Bethesda will also need to purchase additional mining equipment, which will cost $30 million. The equipment will be depreciated using the straight-line method over 6 years, with no estimated salvage value. Since the coal will be completely mined from the proposed site and the contract will expire at the end of four years, Bethesda would plan to sell the equipment at the end of the contract. Bethesda believes that it will be able to sell the equipment for $15 million at that time.
Under the terms of the contract, Bethesda would provide Mid-Ohio with 600,000 tons of coal per year at a price of $34 per ton. Bethesda believes that coal production from the mine will be 650,000 tons, 725,000 tons, 810,000 tons, and 740,000 tons, respectively, over the next four years. The excess production will be sold on the spot market at an average of $40 per ton. Bethesda expects variable costs of $13 per ton and fixed costs other than the depreciation of $2,500,000 per year. The mine will require an investment in net working capital of 5% of the expected sales for the next year. At the end of the contract, this working capital will be freed up for use in other projects.
Bethesda will be responsible for reclaiming the land at the termination of the mining operation. This reclamation will occur at the end of year 4, at a cost of $4 million. At the conclusion of reclamation (still within year 4), Bethesda will donate the property to charity and will receive a resulting in a tax savings of $2 million.
Bethesda's income tax rate is expected to be 35%. Assume that losses in any year will result in a tax credit (negative income taxes). Bethesda has a required return of 12% on new strip mine projects.
You have been approached by the president of the company to analyze the proposed investment. You should compute the free cash flows for each year of this project (Year 0 through Year 4). Then, you should compute the payback period, accounting rate of return, benefit-cost ratio, net present value, and internal rate of return for this project. Then provide a recommendation to the president as to whether Bethesda should accept the contract and open the mine.
The problem is a case study for Bethesda Mining. The company is evaluating whether to undertake an investment.