Bethesda

Mining Company
Barcatan, Analyn
Felesedario, Carlitos
Magto, Jela
Bethesda Mining

Bethesda Mining is a midsized 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.
Bethesda Mining

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

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 on 5000 acres of land purchased 10 years ago for $5.4 million. Based on a
recent appraisal, the company feels it could receive $7.5 million on an after-tax
basis if it sold the land today.
Bethesda Mining

Some time ago, the company would simply remove the coal and leave the land
in an unusable condition. Changes in mining regulations now force a company
to reclaim the land; that is, when the mining is completed, the land must be
restored to near its original condition. The land can then be used for other
purposes.
Bethesda Mining

Because it is currently operating at full capacity, Bethesda will need to

purchase additional necessary equipment, which will cost $46 million. The
equipment will be depreciated on a seven-year MACRS schedule. The contract
runs for only four years. At the time the coal from the site will be entirely mined.
The company feels that the equipment can be sold for 60 percent of its initial
purchase price. However, Bethesda plans to open another strip mine at that
time and will use the equipment at the new mine.
Facts of the Case
Bethesda Mining

● Approached by Mid-Ohio Electric Company to supply sulphur coal for its

electric generators
● The contract is good for 4 years
● Bethesda does not have excess capacity to supply the contract. Thus it is
considering to
○ to open a strip mine in Ohio on 5,000 acres of land (company property)
○ to buy additional equipment
The Contract

● 4 years
● Calls for the delivery of 450,000 tons of coal per year
● Contract price per ton of coal is $65
The Strip Mine in Ohio

● 5,000 acres of land

● Purchased 10 years ago at $5.4 million
● Company feels it could receive $7.5 million (after-tax) if it is sold today
● The coal from the site will be entirely mined at the end of the 4-year
contract
● Mining regulations require when the mining is completed, the land must be
restored to near its original condition (Year 5)
The Strip Mine in Ohio

● To restore the land, it will cost $5.5 million

● After such, the company will donate the land to the state to be used as a
public park and recreation area (Year 6)
● Will result in a charitable expense deduction of $7.5 million
 The Strip Mine in Ohio

● Production at the mine is estimated at

○ Year 1 770,000 tons
○ Year 2 830,000 tons
○ Year 3 850,000 tons
○ Year 4 740,000 tons
● Excess production will be sold in the spot market at an average of $82 per ton
● Variable cost: $26 per ton
● Fixed cost: $3.9 million per year
The Equipment

● Purchase cost will be $46 million

● The equipment shall be depreciated on a seven (7) year MACRS schedule
● Can be sold after the contract at 60% of its initial purchase price (MV at end
of 4 years: $27 M)
● However, Bethesda plans to use this equipment at another site to be opened
after the 4-year contract (equipment has alternative use)
Other Data

Working Capital Requirements Tax and Required Rates

● 5% of sales ● Tax rate is 38%

● Will be built up prior to the sales ● Required return on new strip
mine projects is 12%
● Loss in any year will result in a
tax credit
Solve for the following:

● Payback Period
● Profitability Index (PI) Should Bethesda
● Net Present Value (NPV)
● Internal Rate of Return (IRR) Mining take and
open the mine?
Payback Period

Measures the length of time it will take before the receipts from the investment
are sufficient to recover the cost of the investment.

Criteria: Dependent on the firm’s minimum or required payback

Payback Period

Advantages Disadvantages

● Simple and easy to understand ● Does not recognize the time

● Focuses its attention on early value of money
cash inflows and requires that ● Ignores the impact of cash
the project’s payback period be inflows received after payback
within a span of time which is period
acceptable to the company
Profitability Index (PI)

It is the ratio of the total PV of future cash inflows to the initial investment. It is used
to rank projects in a descending order of attractiveness.

Criteria: If the PI is greater than 1, the project is accepted

Any value lower than 1 indicates that the project’s PV is less than the initial
investment. The greater the PI, the more attractive is the project.
Net Present Value (NPV)

Obtained by getting all the cash inflows using the cost of capital less the initial
investment.

Criteria: Any positive NPV is acceptable

Internal Rate of Return (IRR)

Is a discount rate that equates all the present values of the cash inflows to the
initial investment.

In other words, is a discount rate that makes the net present value (NPV) of all
cash flows from a particular project equal to zero. A fair estimation of the IRR
can be determined by means of trial and error and interpolation.

NPV cost of a project = NPV benefits

Criteria: The project with the highest IRRs are accepted

Payback Period

Advantages:

● Simple and easy to understand

● Focuses its attention on early cash inflows and requires that the project’s
payback period be within a span of time which is acceptable to the
company
Steps

1. Sales
2. Change in NWC
3. Operating cash flow
4. Aftertax Salvage Value of Equipment at year 4
5. Total project CF
Total Production

Year 1 Year 2 Year 3 Year 4

To Mid Ohio 450,000 450,000 450,000 450,000

To Spot Market 320,000 380,000 400,000 290,000

Total Production 770,000 830,000 850,000 740,000

To be sold to Mid-Ohio 450,000 tons

Excess production will be sold to the market

 Total Sales

Year 1 Year 2 Year 3 Year 4

Contract Sales 29,250,000 29,250,000 29,250,000 29,250,000

Spot Market Sales 26,240,000 31,160,000 32,800,000 23,780,000

Total Sales 55,490,000 60,410,000 62,050,000 53,030,000

Sales on Mid-Ohio 450,000 tons x $ 26

Sales to Spot Excess production x $ 82

Net Working Capital Requirement

● 5 percent of sales.
● The NWC will be built up in the year prior to the sales.

Year 0 Year 1 Year 2 Year 3 Year 4

Beg. NWC - 2,774,500 3,020,500 3,102,500 2,651,500

End NWC 2,774,500 3,020,500 3,102,500 2,651,500 -

Change in NWC (2,774,500) (246,000) (82,000) 451,000 2,651,500

Initial Investments

Equipment $ 46,000,000

Land (opportunity cost) 7,500,000

Net working Capital (5% of total sales) 2,774,500

Total $ 56,274,500
Operating Cash Flow
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales 55,490,000 60,410,000 62,050,000 53,030,000

Less: Variable Costs 20,020,000 21,580,000 22,100,000 19,240,000

Less: Fixed Costs 3,900,000 3,900,000 3,900,000 3,900,000 5,500,000 7,500,000

Depreciation 6,573,400 11,265,400 8,045,400 5,745,400

EBIT 24,996,600 23,664,600 28,004,600 24,144,600 (5,500,000) (7,500,000)

Less: Tax @ 38% 9,498,708 8,992,548 10,641,748 9,174,948 (2,090,000) (2,850,000)

Net Income 15,497,892 14,672,052 17,362,852 14,969,652 (3,410,000) (4,650,000)

Add: Depreciation 6,573,400 11,265,400 8,045,400 5,745,400

Operating Cash Flow 22,071,292 25,937,452 25,408,252 20,715,052 (3,410,000) (4,650,000)

MACRS Depreciation Rates
Aftertax Salvage Value of Equipment
Book Value of Equipment, end of year 4 14,370,400

Market Value, end of year 4 27,600,000

Taxable gain on sale 13,229,600

Tax @ 38% 5,027,248

Market Value 27,600,000

Less: Tax on sale 5,027,248

Aftertax salvage value 22,572,752

Operating Cash Flow
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Equipment
(46,000,000) 22,572,752

Land (opportunity cost) (7,500,000)

Change in NWC (2,774,500) (246,000) (82,000) 451,000 2,651,500 - -

Operating Cash Flow 22,071,292 25,937,452 25,408,252 20,715,052 (3,410,000) (4,650,000)

Total Project CF (56,274,500) 21,825,292 25,855,452 25,859,252 45,939,304 (3,410,000) (4,650,000)

Payback Period

Initial Investment (56,274,500.00)

Cash Flows

Year 1 21,825,292.00 (34,449,208.00) 1

Year 2 25,855,452.00 (8,593,756.00) 1

Year 3 25,859,252.00 0.33

Payback period 2.33

PV of Cash Flows

Year PV factor @ 12%

1 21,825,292.00 0.8929 19,486,867.86

2 25,855,452.00 0.7972 20,611,808.04

3 25,859,252.00 0.7118 18,406,104.80

4 45,939,304.00 0.6355 29,195,258.20

5 (3,410,000.00) 0.5674 (1,934,925.58)

6 (4,650,000.00) 0.5066 (2,355,834.71)

PV of Total Project CF 83,409,278.60

Profitability Index (PI)

PV of Total Project CF 83,409,278.60

Over: Initial Capital Outlay 56,274,500.00

Profitability Index 1.4821

Net Present Value (NPV)

PV of total project CF 83,409,278.60

Less: Initial Capital Outlay 56,274,500.00

NPV 27,134,778.60
Internal Rate of Return (IRR)
Year Cash Flow PV factor
@ 31.74%

0 (56,274,500.00)

1 21,825,292 0.7591 16,566,943.98

2 25,855,452 0.5762 14,897,617.39

3 25,859,252 0.4374 11,310,009.80

4 45,939,304 0.3320 15,251,542.69

5 (3,410,000) 0.2520 (859,342.09)

6 (4,650,000) 0.1913 (889,502.14) 56,277,269.63

Summary
Criteria Result

Payback period firm's minimum payback period 2.33

Profitability Index if PI is > 1, project is accepted 1.4821

Net Present Value Any positive NPV is acceptable 27,134,778.60

IRR the higher the IRR the better 31.74%

Bethesda Mining should undertake the project.

End of Report

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