1. A huge deposit of copper has just been discovered in Norden. The government of Norden is now soliciting bids for the right to mine the copper. The winner of the contract will have the right to extract 1 million pounds of copper per year. For simplicity, we will assume that this will continue in perpetuity. Currently, the market value of copper is C$0.90 per pound, and the Norden franc is worth C$0.27. Extraction costs, consisting mainly of local labor, are 0.65 Norden francs per pound.
The inflation rate in Norden is a healthy 30% per year, and this is expected to continue. In contrast, Canadian inflation is expected to be only 3% per year. Although relative prices are uncertain, the best bet is that copper prices and extraction costs will rise with inflation. Management of your company has determined the project is acceptable only if it promises to generate a 5% annual real return.
a) What is the maximum dollar amount you are willing to bid for the right to mine the Norden copper? (i.e., what is the fair market value of the right to mine the copper?)
b) You present your analysis to top management. They want to know how your answer would change if they informed you of projections indicating that Norden's inflation rate could accelerate. How do you respond?
c) Top management is also concerned that, although the project may appear profitable now, changes in copper prices and/or exchange rates in the future could render it unprofitable. Comment on the exposure of this project to both copper prices and exchange rates, and discuss how these risks could be hedged.