1Topical Case: Canadian Diamonds
Background
The greatest existing example of a worldwide monopoly is DeBeers Diamond Company. You can thank DeBeers for having to pay many times more for diamond jewelry than it is actually worth. The company was started back in 1870 when Cecil Rhodes bought a plot of land in South Africa from the DeBeers family. Since then, the diamonds mined by DeBeers have been sent to sorting and cutting centers around the world such as Antwerp, Amsterdam, and New York. DeBeers currently controls the supply of roughly 60%–80% of the world's diamonds, depending on who you talk to.
DeBeers flexes its market muscles by severely limiting the supply of diamonds in the market and by price-fixing. However, a few crucial events in the post-WWII diamond market loosened DeBeers' grip on the market. In the 1950s, Russia discovered some diamond deposits in Siberia. DeBeers quickly stepped in and made a deal with the Russian government to have all of its diamonds flow through DeBeers' supply chain. Afterwards, Russia realized the profits that could be made by being independent from DeBeers. As a result, the markets were soon flooded with Russian diamonds. More recently, in the 1990s, diamonds were also discovered in Northern Canada.
BHP Billiton Diamond Company is a competitor of DeBeers in the Canadian market and fought for the right to the diamond mines in Northern Canada. BHP won the right to the Ekati mine, but DeBeers won the rights to other diamond mines in Canada. The Ekati mine is expected to produce annual revenues of $500 million per year for 25 years. BHP and DeBeers fight for control of the Canadian diamond market and BHP Company has very little room for error when competing against DeBeers.
BHP Billiton Diamond Company
BHP Billiton is a very healthy company, bringing in an annual revenue of around $47 billion dollars. But mining diamonds isn't exactly a simple operation. Mining diamonds requires heavy-duty equipment that not only extracts the diamonds, but transports, filters, and treats the diamonds. The heavy reliance on equipment explains why 63.1% of BHP's assets are PPE. Still, this heavy reliance on equipment had its payoffs back in 2006 when BHP had a net margin of 34.16%.
The equipment needed to operate the Ekati mine is demanding. Some of the equipment needed at the mine includes 4 blast drills, 2 hydraulic shovels, 10 bulldozers, 5 loaders, 27 haul trucks, and an excavator. In order for BHP Billiton to be competitive with DeBeers, BHP must have excellent capital budgeting procedures.
Purchasing Equipment
Jane Miller, a corporate finance major from the University of Toronto, was recruited by BHP Billiton while she was working for a coal mining company in Eastern Canada. After a few months at BHP, Jane was eager to prove her worth to her manager by taking on a meaningful project. Her only problem: she had yet to see a project of significance thrown her way.
Finally, after several more months at the company, Jane's boss approached her with a very important task. To compete with DeBeers' decision to open another mine in Northern Canada, BHP has decided to expand its operations at the Ekati mine. The expansion will require additional mining equipment, including two additional hydraulic shovels. Jane's boss wants to know whether the company should buy used hydraulic shovels or go with new hydraulic shovels. Jane sets to work to determine all of the costs and cash flows associated with the purchasing of the shovels.
A used hydraulic shovel costs $14,570,000, another $45,000 to transport it to the site, and an additional $5,000 to make final assembly and modifications to the shovel at the site. The used shovels have an expected life of 10 years. The used shovels will be depreciated to zero using straight-line depreciation and will have a zero salvage value. Each used shovel is expected to sell for $4,000 in scrap metal. The annual cash flows for the used hydraulic shovels are displayed in here:
A new hydraulic shovel costs $30,330,000, another $20,000 to transport it from the nearest dealer in Edmonton, and a final $3,000 for the modification and assembly of the shovel at the site. The new shovels have an expected life of 15 years. The shovels will be depreciated to zero using straight line depreciation. The hydraulic shovels will be sold after 10 years of use for $321,000 and the buyer will be expected to pay for the transportation of the shovels they purchased. The annual cash flows for the new hydraulic shovels are displayed in here:
According to the company's past numbers, Jane determines that additional revenue created by the hydraulic shovels is dependent upon the amount of earth they excavate. For every ton of earth excavated, the company gains $2,000 in additional revenue. Jane understands the importance of estimating the annual costs associated with operating the shovels and handling the additional excavated earth. For every ton of earth excavated by the shovels, the company spends $1,900 to operate the shovel (including labor), transport the earth to the plant, and all other additional operational costs incurred at the plant. The shovels will be operated for an average of 10 hours a day for 320 days a year. They are not expected to be in operation because of holidays and poor weather, inhibiting operations.
Questions
What is the initial outlay for the used hydraulic shovels? New hydraulic shovels?
Calculate the annual cash flows for the new hydraulic shovels. Used hydraulic shovels?
How much will BHP Billiton have to pay in annual taxes for each type of shovel?
What is the terminal cash flow for the new hydraulic shovel? Used hydraulic shovel?
What is the NPV for both shovel types?
What is the payback period for both shovel types?
What is the IRR for both shovel types?
What is the profitability index for both types of shovels?
Are there any ranking methods that rank the shovels differently?
Which shovels should Jane suggest that the company purchase?