Question

Recent increases in gold prices have prompted TomKat Goldfields, Inc. to consider reopening an inactive mine.  Last year, TomKat paid a team of geologists $200,000 to assess the amount of recoverable gold at the mine.  The geologists estimated that 45,000 troy ounces of gold could still be recovered from the mine.   The price of gold is now $800 per ounce, and hedge contracts can be used to lock in this price for up to five years.  Direct excavation costs would be $5.2 million per year for five years.   These expenditures would allow recovery of 5,000 ounces of gold the first year, and 10,000 ounces in each of the second through fifth years.  New mining equipment with a cost of $8 million would be needed right away. The equipment could be depreciated according to the five year MACRS schedule, and would be sold at the end of year 5 for an estimated salvage value of $1.2 million.  The tax rate is 21%.

The geologists’ report noted that TomKat has sufficient furnace capacity at its platinum plant, as Tomkat’s platinum division uses only 60% of the furnace capacity.   Currently, that excess capacity is used to process ore for Bre-Y Mining Inc., in exchange for a payment of $800,000 per year.  The out-of-pocket cost of running the furnaces (which would be unchanged in any case) is $1.4 million per year, and processing the gold from Tomkat’s mine would require 40% of the furnace capacity. The discount rate is 10% per year.  You can assume that TomKat has several million dollars of taxable income from other profitable operations. (a) Forecast the incremental cash flows to TomKat that would result from reopening the mine, on a year-by-year basis. (b) Compute the NPV and the IRR of the proposal to reopen the gold mine at this point in time.

Answer 1

a)	INCREMENTAL CASH FLOWS:	0	1	2	3	4	5
	Gold recovery in ounces		$              5,000	$                10,000	$                10,000	$                     10,000	$                     10,000
	Sales at $800/ounce		$      40,00,000	$          80,00,000	$          80,00,000	$               80,00,000	$               80,00,000
	Direct excavation costs		$      52,00,000	$          52,00,000	$          52,00,000	$               52,00,000	$               52,00,000
	Depreciation [MACRS 5 YEAR]		$      16,00,000	$          25,60,000	$          15,36,000	$                 9,21,600	$                 9,21,600	460800	8000000
			[8000000*0.2]	[8000000*0.32]	[8000000*0.192]	[8000000*0.1152]	[8000000*0.1152]	[8000000*0.0576]
	Loss of revenue from Bre-Y Mining		$        8,00,000	$             8,00,000	$             8,00,000	$                 8,00,000	$                 8,00,000
	NOI (Sales-Direct excavation costs-Depreciation-Loss of revenue from Bre-Y Mining)		$    -36,00,000	$           -5,60,000	$             4,64,000	$               10,78,400	$               10,78,400
	Less: Tax at 21% [NOI*21%]		$      -7,56,000	$           -1,17,600	$                97,440	$                 2,26,464	$                 2,26,464
	NOPAT		$    -28,44,000	$           -4,42,400	$             3,66,560	$                 8,51,936	$                 8,51,936
	Add: Depreciation		$      16,00,000	$          25,60,000	$          15,36,000	$                 9,21,600	$                 9,21,600
	OCF		$    -12,44,000	$          21,17,600	$          19,02,560	$               17,73,536	$               17,73,536
	Capital expenditure	$     80,00,000
	Salvage value						$               12,00,000
	Tax on gain = (1200000-460800)*21% =						$                 1,55,232
	Incremental cash flows [OCF-Capital expenditure-+Salvage value-Tax on gain]	$    -80,00,000	$    -12,44,000	$          21,17,600	$          19,02,560	$               17,73,536	$               28,18,304
b)	PVIF at 10% [PVIF = 1/1.1^n]	1	0.90909	0.82645	0.75131	0.68301	0.62092
	PV at 10% [Incremental cash flows*PVIF]	$    -80,00,000	$    -11,30,909	$          17,50,083	$          14,29,421	$               12,11,349	$               17,49,945
	NPV (Sum of PV's of Years 0 to 5]	$    -29,90,111
	IRR:
	IRR is that discount rate for which NPV is 0. It has to be found out by trial and error to get 0 NPV.
	IRR would be negative as the undiscounted cash inflows total to		$      73,68,000	which is less
	than the iniital investment of $8,000,000.
	DECISION:
	As the NPV is negative, the project is not viable.