Raul Finance Assingment Help With Solution
Raul is a financial analyst working for Appalachian Providence Mining Corporation (APMC), a medium-size resource company that mines metal ores and partially treats them on site to decrease ore volume before shipping to a larger smelter owned by the company for final metal extraction. Some of the onsite leaching at the mine requires use of dangerous chemicals, so APMC management has to implement measures that ensure the safety of its workers. Past accidents in the industry have led to heavy and restrictive government agency enforcement of safety and environmental practices. Some environmental activists have suggested that operations like APMC’s mine should be shut down to preserve the pristine wilderness. However, company officials have assured the government and the public that the firm operates within government guidelines.
APMC has the opportunity to increase its profits by purchasing a new upgrader that will further process its ore onsite through a closed-loop chemical treatment. The chemicals will enhance metal recovery, and the chemical residue will be recovered for re-use. It is expected that the use of this new upgrader process will increase the value of the minerals shipped to the smelter by 20%, or $2,000,000 per year over the 10-year life of the equipment. Chemicals would cost about $300,000 per year, and annual labour and maintenance costs would increase by $350,000. Senior management is strongly in favour of this project that it believes will significantly increase profitability of the mine. However, the risks to the environment and safety would be substantial without appropriate prevention measures.
The new equipment would cost $4,000,000 now, plus an additional $1,000,000 for transportation and installation. It is being added to a large tax pool of equipment with a capital cost allowance (CCA) rate of 30%. At the end of 10 years, it is expected that this processing equipment will have a salvage value of $700,000. In addition, there will be a one-time $500,000 tax deductible expense for site clean-up.
During the life of the project, it is expected that there will be a change in non-cash net working capital. Accounts receivable will increase by $250,000 and inventory will increase by $675,000. Accounts payable will also increase by $125,000.
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In his consultations with company engineers, Raul has learned that there is a small annual probability of 1.5% of a significant environmental issue with the proposed process. Should this occur, the cost for clean-up would range from $250,000 to $20,000,000 and the engineering department has estimated that it would average about $5,000,000 to clean up the environmental damage. Raul plans to incorporate this possibility in his estimated costs. If a worker were also involved in an accident, there could be additional treatment and compensation costs, but the senior management of the company is confident that safety precautions would not allow this to occur, so Raul should not include an estimate for these potential financial costs.
This project is independent of other company projects. APMC is financed with 40% debt to total assets, with a current cost of debt of 8%, and the company’s effective corporate tax rate is 30%. However, Raul has learned that XLX, a company with a similar mine as its only asset, has a stock market beta of 1.55, a debt to equity ratio of 0.6, and an income tax rate of 20%. The recent economic outlook from a bank advisory service stated that the bank does not expect the long-term government bond rate to change much from 3% over the next few years, and projects a market portfolio premium of about 8% for the same period.
For this question, calculate dollar figures to the nearest dollar, and returns to four decimal places.
a. Find the appropriate discount rate that should be used for this project, based on the information provided.
b. Assume risk-adjusted cost of capital for this project is 12%. Find the net present value (NPV) of this project, using the cash flow assumptions given above. What is the total initial outlay?
c. Should this project be accepted based on your financial analysis? What other issues should management consider?
d. Assume that an actual environmental issue requiring clean-up occurs once in year 2 only, with no other incidents. What would the revised NPV of the investment be, if the cost were at the maximum of the estimated range? You can begin with the original NPV estimate from part (a) and adjust for this change.
e. Assume the original adjusted cost of capital for this project is 12%. Unfortunately, before the project assessment is completed, a competing mine has a catastrophic accident involving a chemical spill. The company banker states that the bank must increase the debt interest from 8% to 10% to compensate for the extra risk it faces in financing APMC. Also, company shares drop in price, resulting in an increase in the cost of equity component of the cost of capital by 3%. What is the impact of these changes on (i) the company’s adjusted cost of capital and (ii) the NPV of this investment?
f. The chief company geologist warns Raul that there is a chance that the ore body might be exhausted shortly before the end of the 10-year life of the upgrader. If this happens, it is likely that other equipment will already be sold by the end of the life of this asset, and there will be no remaining value in the equipment UCC pool. Raul wants to know if this would have a significant impact on the NPV of the investment.
Assume the cost of capital is 12% as in part (b) and calculate the change in NPV that will result from this change in assumptions. Assume that the 10-year life of the equipment remains, and that it can still be sold for $700,000 salvage. You can begin with the NPV estimate from part (e) and adjust for this change. Comment on your results.
g. If you were in Raul’s position, how would you summarize the advantages and disadvantages of this investment proposal for senior management? What recommendation would you make?
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