Problem:
Harrington Explorations Inc. is interested in expanding it copper mining operations Indonesia. The area has long been noted for its rich deposits of copper, ore with copper prices at near record levels, the company is considering an investment of $60 million to open operations into a new vein of ore that was mapped by company geologists four years ago. The investment would be expensed (a combination of depreciation of capital equipment and depletion costs associated with using up the ore deposits) over five years toward a zero value. Because Harrington faces a corporate tax rate of 30%, the tax savings are significant.
The company's geologists also estimate that the ore will be of about the same purity as existing deposits, such that it will cost $150 to mine and process a ton of ore containing roughly 15% pure copper. The company estimates that there are 75,000 tons of ore in the new vein that can be mined and processed over the next five years at a pace o 15,000 tons per year.
Harrington's CFO asked one of his financial analysts to come up with an estimate of the expected value of the investment using the forward price curve for copper as a guide to the value of the future copper production. The forward price curve for the price per ton of copper spanning the next five years when the proposed investment would be in production is as follows:
2011 - $7,000/Ton
2012 - $7,150/ton
2013 - $7,200/ton
2014 - $7,300/ton
2015 - $7,450/ton
In a study commissioned by the CFO last year, the firm's cost of capital was estimated to be 9.5%. The risk-free rate of interest on five year Treasury bonds is 5.5%.
Q1. Estimate the after-tax (certainty-equivalent) project free cash flows for the project over its five year productive life.
Q2. Using the certainty-equivalent valuation methodology, what is the NPV of the project using the certainty-equivalent methodology and its is negative. When the firm's CFO sees the results of the analysis, he suggests that something must be wrong because his own analysis using conventional methods (i.e. expected cash flows and the firm's weighted average cost of capital) produces a positive NPV of more than $450,000. Specifically, the estimates that the price of copper for 2011 would indeed be $7,000 per ton but that this would increase 12% per year over the five-year life of the project. How should the analyst respond to the CFO's concerns?