Case study: Pickins Mining
Pickins Mining is a midsized coal mining company with 20 mines situated in Ohio, West Virginia and Kentucky. The company operates deep mines and also 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 Pickins, has been hard-hit by environmental regulations. Recently, though, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Pickins has just been approached by Middle-Ohio Electric Company with a request to supply coal for its electric generators for the next 4-years. Pickins 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 after-tax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are eliminated 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 the 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, Pickins will require to purchase additional equipment, which will cost $46 million. The equipment will be depreciated on a 7-year MACRS schedule. The contract just 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. Though, Pickins 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 450,000 tons of coal per year at a price of $65 per ton. Pickins Mining feels that coal production will be 770,000 tons, 830,000 tons, 850,000 tons, and 740,000 tons, respectively, over the next 4-years. The excess production will be sold in the spot market at an average of $82 per ton. Variable costs amount to $26 per ton and fixed costs are $3.9 million per year. The mine will need a net working capital investment of 5 % of sales. The NWC will be built up in the year previous to the sales.
Pickins will be responsible for reclaiming the land at termination of the mining. This will takes place in Year 5. The company employs an outside company for reclamation of all the company's strip mines. It is estimated the cost of reclamation will be $5.5 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 take place in Year 6 and result in a charitable expense deduction of $7.5 million. Pickins faces a 38 % tax rate and has a 12 percent required return on new strip mine projects. Suppose a loss in any year will outcome in a tax credit.
You have been approached by the president of the company with a request to analyze the project. Compute the payback period, profitability index, net present value and internal rate of return for the new strip mine. You require to show all your computations. Should Pickins Mining take the contract and open the mine? Explain in detail, showing computations, so the instructor can follow your thoughts.
You might as well comprise an Excel spreadsheet if you would like to show the calculations that way (in addition to the paper part).
Students are to follow the guidelines for two page papers (which means that all papers will have three sections: Introduction, Analysis and Conclusion). Place the answers to the questions in the analysis and make certain you have all the details for the calculations. All papers are to use APA standards and have at least three citations.