Question

Minicase Maxine Peru Ceo Peru Resources Hardly Noticed Plate Current Price High Quality Hy Q26808116 . . .

Answer 1

The spreadsheet at the Online Learning Center presents the base-case analysis for the mining project. Inflation is assumed to be 3.5%, but most costs increase in line with inflation. Thus, we deal with real quantities in the spreadsheet and keep all quantities except for depreciation at their constant real values. The real value of the depreciation expense thus falls by 3.5% per year. For example, real depreciation for the expensive design in year t is:

         Real depreciation =
$10 million /7 (1.035)'

The real discount rate is (1.14/1.035) - 1 = 0.10 = 10%.

Notice that the cheaper design seems to dominate the more expensive one. Even if the expensive design ends up costing $10 million, which appears to be the best-case outcome, the cheaper design saves $1.7 million up front, which results in higher net present value. If the cost overruns on the expensive design, the advantage of the cheap design will be even more dramatic.

We are told that the two big uncertainties are construction costs and the price of the transcendental zirconium (TZ). The following table does a sensitivity analysis of the impact of these two variables on the NPV of the expensive design. The range of initial costs represents a pessimistic outcome of a 15% overrun (i.e., $1.5 million) combined with environmental regulation costs of an additional $1.5 million. The optimistic outcome, which we arbitrarily take to entail costs of only $8 million, is probably less relevant. It seems from the case description that there is little chance of costs coming in below $10 million.

	Range of Input Variables	Resultant Net Present Values
Variable	Pessimistic	Expected	Optimistic	Pessimistic	Expected	Optimistic
Initial cost	$13m	$10m	$8m	-$0.72m	$1.63m	$3.20m
TZ price	$7,500	$10,000	$14,000	-$1.06m	$1.63m	$5.94m

The following table repeats this analysis for the cheaper design. Here, the uncertainty in initial cost is due solely to the environmental regulations. We are told that this design will not be subject to significant other cost overruns.

	Range of Input Variables	Resultant Net Present Values
Variable	Pessimistic	Expected	Optimistic	Pessimistic	Expected	Optimistic
Initial cost	$9.8m	$8.3m	NA	$0.68m	$1.63m	NA
TZ price	$7,500	$10,000	$14,000	-$0.83m	$1.86m	$6.16m

Notice that the NPV of the cheaper design exceeds the NPV of the expensive one by about $0.22 million regardless of the price of TZ.

In this case, there do not seem to be any inherent relationships among the chief uncertainties of this project. The price of TZ is likely to be unaffected by the cost of opening a new mine. Thus, scenario analysis does not add much information beyond that provided by sensitivity analysis.

One can make a case for delaying construction. If the firm waits a year to see how the price of TZ evolves, the firm may avoid the negative NPV that would result from a low price. Whether it is worth waiting depends on the likelihood that the price will fall.

There is less of a case to be made for delaying construction over the uncertainty of cost overruns. It is unlikely that much of the uncertainty regarding initial cost would be resolved by waiting-the firm probably needs to go into production to learn if there will be overruns.

If the firm goes ahead with the cheaper design, it does not seem necessary to wait to see how the environmental regulations turn out. NPV is positive regardless of the outcome for this variable, so it would not affect the decision of whether to go ahead with the project. The option to walk away from the project would be irrelevant, at least with regard to this variable.