Argon Mining plc is investigating the possibility of purchasing an open-cast coal mine in South Wales at a cost of 2.5 million which the British Government is selling as part of its privatisation programme. The companys surveyors have spent the last three months examining the potential of the mine and have incurred costs to date of 0.2 million. The surveyors have prepared a report which states that the company will require equipment and vehicles costing 12.5 million in order to operate the mine and that these assets can be sold for 2.5 million in four years time when the coal reserves of the mine are exhausted. The assistant to the Chief Financial Officer of the company has prepared the following projected profit and loss accounts for each year of the life of the mine. Projected Profit and Loss Accounts (m) Year 1 2 3 4 Sales 9.4 9.8 8.5 6.3 less Wages and salaries (2.3) (2.5) (2.6) (1.8) Selling and distribution costs (1.3) (1.2) (1.5) (0.6) Materials and consumables (0.3) (0.4) (0.4) (0.2) Depreciation and equipment (2.5) (2.5) (2.5) (2.5) Head office expenses (0.6) (0.6) (0.6) (0.6) Survey costs (0.4) Interest charges Net profit (loss) (1.2) (1.2) (1.2) (1.2) 0.8 1.4 (0.3) (0.6) In his report to the Chief Financial Officer, the assistant recommends that the company should not proceed with the acquisition of the mine as the profitability of the proposal is poor. The following additional information is available: (i) The project will require an investment of 0.5 million of working capital from the beginning of the project until the end of the useful life of the mine. (ii) The wages and salaries expenses include 0.5 million of working capital in Year 1 for staff who are already employed by the company but who would be without productive work until Year 2 if the project does not proceed. However, the company has no intention of dismissing these staff. After Year 1, these staff will be employed on another project of the company. (iii) One-third of the head office expenses consists of amounts directly incurred in managing the new project and two-thirds represents an apportionment of other head office expenses to the project to ensure that it bears a fair share of these expenses. (iv) The survey costs include those costs already incurred to date, and which are to be written off in the first year of the project, as well as costs to be incurred in the first year if the project is accepted. (v) The interest charges relate to finance required to purchase the equipment and vehicles necessary to carry out the project. (vi) After the mine has been exhausted, the company will be required to clean up the site and to make good the damage to the environment resulting from its mining operations. The company will incur costs of 0.4 million in Year 5 in order to do this. The company has a cost of capital of 12 per cent. Ignore taxation. Required (a) Using what you consider to be the most appropriate investment appraisal method, prepare calculations which will help the company to decide whether or not to proceed with the project. (b) State, giving reasons, whether you think the project should go ahead. (c) Explain why you consider the investment appraisal method selected in (a) above to be most appropriate for evaluating investment projects.
Solution: a. We should evaluated projects based on their cash flows and not their profit or loss. Secondly, we should consider only those expense/income/cash flows that comes as a result of the project. One of best ways to evaluate projects is Net Present Value (NPV) method. If the NPV is positive then the project is good to go. So, we will build a financial forecast based on the incremental cash flows because of the project from the point of view of the all-capital holders (both debt and equity). The costs which are already incurred on the project should not be considered for financial evaluation as those are sunk costs. b. Since the NPV of the project is positive at 3.59 million (as computed in part-c answer), the company should go ahead with the project (calculations are shown below). c. In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages. All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR’s major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. Since we have negative cash flows in 2 years, we will 2 IRR. Hence, NPV is the best suited method….
ars/Year 1 2 3 4 Comments Sales 9.40 9.80 8.50 6.30 Wages and salaries -2.50 -2.60 -1.80 0.5 has been removed in year 1 as the working capital is not an expense but a cash outflow which has been considered as initial investment. Further, the remaining wages and salaries will be incurred even if the project is not undertaken. So, we will coonsider the wages and salaeries as 0 in year 1 Selling and distribution costs -1.30 -1.20 -1.50 -0.60 Materials and consumables -0.30 -0.40 -0.40 -0.20 EBITDA 7.80 5.70 4.00 3.70 Depreciation and equipment -2.50 -2.50 -2.50 -2.50 Operating profit 5.30 3.20 1.50 1.20 Head office expenses -0.20 -0.20 -0.20 -0.20 Only 1/3rd of the expense is directly attribtable to the project Survey costs -0.20 Out of 0.4, 0.2 has been already incurred. Hence we should consider only those cost which will be incurred if the project is undertaken. EBIT 4.90 3.00 1.30 1.00 Add: Depreciation 2.50 2.50 2.50 2.50 Operating cash flows 7.40 5.50 3.80 3.50 Terminal cash flows – sale of mine assets 2.50 Terminal cash flows – recovery of working capital 0.50 Terminal cash flows – environmental damage costs in year 5 -0.40 Initial investment – equipment and vehicle -12.50 Initial investment – purchasing the mine -2.50 Initial investment – working capital -0.50 Total cash flows -8.10 5.50 3.80 6.50 -0.40 Discounted cash flows (at 12% discount rate) -7.23 4.38 2.70 4.13 -0.40 N PV of the project (sum of the discounted cash flows) 3.59