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Capital Investment

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 5,000 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 aftertax 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
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. As they are currently operating at full capacity,
Bethesda will need to purchase additional equipment, which will cost $65 million.
The equipment will be depreciated on a seven-year MACRS schedule. The
contract only runs for four years. At that 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 the delivery of 500,000 tons of coal per year at a price of $84
per ton. Bethesda Mining feels that coal production will be 750,000 tons, 810,000
tons, 830,000 tons, and 720,000 tons, respectively, over the next four years. The
excess production will be sold in the spot market at an average of $95 per ton.
Variable costs amount to $43 per ton and fixed costs are $5.2 million 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
of all the company’s strip mines. It is estimated the cost of reclamation will be $5.4
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 as a condition to receive the
necessary mining permits. This will occur in Year 5 and result in a charitable
expense deduction of $7.5 million. Bethesda has a 21 percent tax rate and a
required return of 12 percent on new strip mine projects. Assume a loss in any
year will result in a tax credit.
Assignment Directions
Write a case analysis of 1,000 – 1,250 words (4 to 5 pages), content (title
page and reference page not included) in proper APA format, covering the
following requirements:
You have been approached by the president of the company with a request to
analyze the project. Define, calculate, discuss, and use decision criteria to assess
the investment using the following methods:

Payback period.
Profitability index
Net present value
Internal rate of return
Based on your analysis, should Bethesda Mining take the contract and open the
mine? In your analysis, discuss the advantages and disadvantages of using each
method for capital investment decisions. Discuss any other capital investment
techniques that you would use to help you make a more informed decision. Are
there any other variables that they should consider in their decision?

Full Answer Section

Project Overview and Financial Assumptions

The proposed project involves opening a new strip mine on 5,000 acres of land in Ohio. The land was purchased 10 years ago for $5.4 million but has a current after-tax market value of $7.5 million, representing a significant opportunity cost. The project necessitates the purchase of new equipment costing $65 million, which will be depreciated using a seven-year MACRS schedule. Although the contract spans four years, the equipment is expected to be sold for 60% of its initial purchase price at the end of the project (Year 4) for use in another mine. The contract with Mid-Ohio Electric Company requires the delivery of 500,000 tons of coal annually at a price of $84 per ton. Bethesda Mining anticipates total production to be 750,000, 810,000, 830,000, and 720,000 tons for Years 1 through 4, respectively. Excess production beyond the contract amount will be sold on the spot market at an average of $95 per ton. Variable costs are estimated at $43 per ton, and fixed costs are $5.2 million per year. A net working capital (NWC) investment equal to 5% of annual sales is required, built up in the year prior to the sales. This NWC will be fully recovered at the project's termination. Reclamation of the land, estimated at $5.4 million, will occur in Year 5. In the same year, the company plans to donate the reclaimed land to the state, resulting in a charitable expense deduction of $7.5 million. Bethesda Mining operates with a 21% tax rate and requires a 12% return on new strip mine projects. Any annual loss is assumed to result in a tax credit.

Cash Flow Projections

To accurately assess the project, the incremental cash flows must be determined. Initial Investment (Year 0):

Equipment Cost: -$65,000,000
After-tax Opportunity Cost of Land: -$7,500,000 (foregone sale proceeds)
Net Working Capital (NWC) for Year 1 Sales: -$3,287,500 (5% of Year 1 sales of $65,750,000)
Total Initial Investment (CF0) = -$75,787,500

Annual Operating Cash Flows (Years 1-4):

Year	Production (Tons)	Contract Sales ($84/ton)	Spot Sales ($95/ton)	Total Sales	Variable Costs ($43/ton)	Fixed Costs	Depreciation (7-yr MACRS)	EBIT	Taxes (21%)	NOPAT	OCF (NOPAT + Dep)	Change in NWC	Annual Cash Flow
1	750,000	$42,000,000	$23,750,000	$65,750,000	$32,250,000	$5,200,000	$9,288,500	$19,011,500	$3,992,415	$15,019,085	$24,307,585	-$285,000	$24,022,585
2	810,000	$42,000,000	$29,450,000	$71,450,000	$34,830,000	$5,200,000	$15,918,500	$15,401,500	$3,234,315	$12,167,185	$28,085,685	-$95,000	$27,990,685
3	830,000	$42,000,000	$31,350,000	$73,350,000	$35,690,000	$5,200,000	$11,368,500	$21,091,500	$4,429,215	$16,662,285	$28,030,785	$522,500	$28,553,285
4	720,000	$42,000,000	$20,900,000	$62,900,000	$30,960,000	$5,200,000	$8,118,500	$18,621,500	$3,910,515	$14,710,985	$22,829,485		$22,829,485

Terminal Cash Flows (End of Year 4 / Beginning of Year 5):

After-Tax Salvage Value of Equipment:
- Initial Cost: $65,000,000
- Total Depreciation (Years 1-4): $9,288,500 + $15,918,500 + $11,368,500 + $8,118,500 = $44,694,000
- Book Value at Year 4: $65,000,000 - $

Sample Answer

Capital Budgeting Analysis: Bethesda Mining Strip Mine Project

Introduction

Bethesda Mining, a prominent midsized coal mining company, is presented with a significant strategic decision: whether to undertake a new strip mining project in Ohio to fulfill a four-year contract with Mid-Ohio Electric Company. This decision involves substantial capital expenditure, complex cash flow projections, and consideration of environmental regulations and market dynamics. To provide a comprehensive assessment, this analysis will define, calculate, and evaluate the project using four fundamental capital budgeting methods: Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI). Furthermore, it will discuss the advantages and disadvantages of each method, propose additional techniques for a more informed decision, and highlight other critical variables for consideration.