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. 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 on 5000 acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company feels it could receive $5 million on an after-tax basis if it sold the land today. Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. 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. Because it is currently operating at full capacity, Bethesda will need to purchase additional necessary equipment, which will cost $30 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. The contract calls for delivery of 600,000 tons of coal per year at a price of $34 per ton. Bethesda Mining feels that coal production 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 in the spot market at an average of $40 per ton. Variable costs amount to $13 per ton, and fixed costs are $2,500,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales. Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in year 5.The company uses an outside company for reclamation will be $4 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area. This will occur in year 6 and result in a charitable expense deduction of $6 million. Bethesda faces a 38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax credit. You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index, average accounting return, net present value, internal rate of return, and modified internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?

Bethesda Mining Company To be able to analyze the project, we need to calculate the projects NPV, IRR, MIRR, Payback Period, and Profitability Index. Since net working capital is built up ahead of sales, the initial cash flow depends in part on this cash outflow. So, we will begin by calculating sales. Each year, the company will sell 600,000 tons under contract, and the rest on the spot market. The total sales revenue is the price per ton under contract times 600,000 tons, plus the spot market sales times the spot market price. The sales per year will be:

Year 1 Contract 20,400,000 Spot $2,000,000 Total $22,400,000

2 $20,400,000 $5,000,000 $25,400,000

3 $20,400,000 $8,400,000 $28,800,000

4 $20,400,000 $5,600,000 $26,000,000

The current after-tax value of the land is an opportunity cost. The initial outlay for net working capital is the percentage required net working capital times Year 1 sales, or: Initial net working capital = .05($22,400,000) = $1,120,000 So, the cash flow today is: Equipment $30,000,000 Land 5,000,000 NWC 1,120,000 Total $36,120,000 Now we can calculate the OCF each year. The OCF is:

Year 1 Annual Revenue Less: Variable Costs Less: Fixed Costs Less: Depreciation EBIT Tax @ 34% Net Income Add: Depreciation OCF $22,400,000 $8,450,000 $2,500,000 $4,290,000 $7,160,000 $2,434,400 $4,725,600 $4,290,000 $9,015,600

2 $25,400,000 $9,425,000 $2,500,000 $7,350,000 $6,125,000 $2,082,500 $4,042,500 $7,350,000 $11,392,500

3 $28,800,000 $10,530,000 $2,500,000 $5,250,000 $10,520,000 $3,576,800 $6,943,200 $5,250,000 $12,193,200

4 $26,000,000 $9,620,000 $2,500,000 $3,750,000 $10,130,000 $3,444,200 $6,685,800 $3,750,000 $10,435,800

$4,000,000

$6,000,000

($4,000,000) ($6,000,000) ($1,360,000) ($2,040,000) ($2,640,000) ($3,960,000) ($2,640,000) ($3,960,000)

Years 5 and 6 are of particular interest. Year 5 has an expense of $4 million to reclaim the land, and it is the only expense for the year. Taxes that year are a credit, an assumption given in the case. In

Year 6, the charitable donation of the land is an expense, again resulting in a tax credit. The land does have an opportunity cost, but no information on the after-tax salvage value of the land is provided. The implicit assumption in this calculation is that the after-tax salvage value of the land in Year 6 is equal to the $6 million charitable expense. Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of next years sales, so the NWC requirement each year is: Y e a r 0 1 2 3 4 56 Beginning WC $1,120,000 $1,270,000 $1,440,000 $1,300,000 Ending WC $1,270,000 $1,440,000 $1,300,000 $0 NWC CF ($150,000) ($170,000) $140,000 $1,300,000

The last cash flow we need to account for is the salvage value. The fact that the company is keeping the equipment for another project is irrelevant. The after-tax salvage value of the equipment should be used as the cost of equipment for the new project. In other words, the equipment could be sold after this project. Keeping the equipment is an opportunity cost associated with that project. The book value of the equipment is the original cost, minus the accumulated depreciation, or: Book value of equipment = $30,000,000 4,290,000 7,350000 5,2502,000 3,750,000 Book value of equipment = $9,360,000 Since the market value of the equipment is $18 million, the equipment is sold at a gain to book value, so the sale will incur the taxes of: Taxes on sale of equipment = ($18,000,000 9,360,000)(.34) = $2,937,600 And the after-tax salvage value of the equipment is: After-tax salvage value = $18,000,000 2,937,600 After-tax salvage value = $15,062,400 So, the net cash flows each year, including the operating cash flow, net working capital, and after-tax salvage value, are: Year 0 Capital Spending Opportunity Cost NWC OCF Total Project Cash Flow ($30,000,000) ($5,000,000) ($1,120,000)

1 $0

2 $0

3 $0

4 $15,062,400

5 $0

6 $0

($150,000) $9,015,600 $8,865,600

($170,000) $140,000 $1,300,000 $11,392,500 $12,193,200 $10,435,800 ($2,640,000) ($3,960,000) $11,222,500 $12,333,200 $26,798,200 ($2,640,000) ($3,960,000)

($36,120,000)

So, the capital budgeting analysis for the project is: Payback period = 3 + $3,698,700/$26,798,200 Payback period = 3.14 years

Profitability index = Profitability index = 1.08 The equation for IRR is: I have calculated the IRR using Trial & Error as noted on the attached excel sheet, the IRR = 15.6%. MIRR = 13.39% Year 0 ($36,120,000) 1 ($36,120,000) $3,047,225

OCF PV Factor @ 12% PV NPV

1 $8,865,600 0.8929 $7,915,714

2 3 4 5 6 $11,222,500 $12,333,200 $26,798,200 ($2,640,000) ($3,960,000) 0.7972 0.7118 0.6355 0.5674 0.5066 $8,946,508 $8,778,528 $17,030,741 ($1,498,007) ($2,006,259)

From the above, the project should be undertaken since it has a positive Net Present Value, an IRR and MIRR that are higher than the required rate of return, a payback period that is less than 4 years, and finally a Profitability Index that is higher than 1. Please see the attached excel sheet for all calculations.