Case Study: RedSand Ltd.
RedSand Ltd. is a gold mining and exploration company listed in the Australian Securities Exchange. Almost all its activities are centred in Western Australia. It recently discovered 350,000 ounces of gold in the Pilbara region in Western Australia. RedSand can extract 50,000 ounces per year from this mine and the total gross revenue is a function of the gold price. Life of the project is estimated to be six years. Not all the discovered gold can be extracted from any gold mine. The variable cost is estimated to be 30% of the sales revenue. Annual cash fixed costs, excluding depreciation and the costs of permanent workforce, are estimated to be $3 million.
The projected future gold prices are as follows:
Year 2015 2016 2017 2018 2019 2020
Gold price $1,300 $1,320 $1,400 $1,400 $1,300 $1,275
The gold discovery is a result of a five-year feasibility study that cost $2 million. The firm still needs to incur a capital expenditure of $30 million in 2015 to develop the mine. This cost can be deducted in equal instalments from revenues over 5 years for tax purposes.
Redsand has already paid $10 million to the West Australian Government to lease the land. This lease payment is non-refundable and non-transferable. RedSand has no alternative use for the land if the mining project does not go ahead. Mining equipment and mining quarters will need to be constructed at the beginning of 2015 at a cost of $70 million and this should be depreciated using 20 percent straight -line method. Assume that the equipment and mining quarters can be sold for 10 percent of initial cost at the end of the project, i.e., at the end of six years.
The salaried workforce (indirect labour) will cost $10 million per annum but 30 per cent of this workforce will come from existing operations elsewhere in Western Australia. If this mine is not put into operation, the workforce that comes from existing operations would lose their jobs at the end of 2014 and they will have to be paid redundancy payments amounting to $2,000,000 at the end of 2015.
Working capital is expected to be $8 million at the start of the project and this will be fully recovered at the end of the project. The effective tax rate of RedSand is 30 per cent and the appropriate discount rate (hurdle rate) is 15 per cent. However, the BCA bank is willing to finance the project at an interest rate of 10% per annum (APR). Interest will be charged quarterly.
Question 1
Is it financially worthwhile for RedSand to start production? Use the main investment appraisal methods (NPV, IRR) to justify your answer. (Show all cash flow statements and computations).
Question 2
Contrast and critically evaluate the NPV and IRR methods. What do you think is the best method? Why?
Question 3
What are the main risk factors faced by RedSand in the mining project? Discuss these in detail.
Question 4
Perform a sensitivity analysis on the NPV, at 90% and 110% of the given values of the following variables: yearly quantity of gold extraction, gold price. (Change the values of both variables at the same time to the same direction). Calculate the best-case and worst-case NPV for the project. Evaluate your results.
Question 5
Discuss any other qualitative factors the Board of Directors should consider when making a decision.
Question 6
Assuming you are the CFO of the company, write an executive summary for the project.