Mr. Hunter, CEO of MT Mining Company (MTMC), received a report from the engineering department. The report describes a proposed new mine on the North Ridge of MT. A gold mine had been discovered on the land owned by MTMC. The land is now leased to another company for $300,000 a year (opportunity cost). The lease is going to expire but can be renewed with the same condition. Tests indicated that this mine can produce 90,000 ounces gold for the first year and the production can increase 10 percent for the next four years then decreases 15 percent for next three years. The resources will be exhausted by the end of the eighth year.
MTMC is currently very conservatively financed. Mr. Hunter believes that MTMC can raise $60 million by issuing bond with 9 percent coupon interest rate. However, when the bond is issued, the market interest can fluctuate in the range of 7% to 11%.
The initial cost of the project includes the purchase of necessary machinery ($50 million), one-time environmental protection fee of $2.5 million, and designing fee of $6.5 million. The project needs $1 million as working capital.
The fixed operating cost of the mine is $850,000 per year. The mine needs to hire 20 engineers and managers, 200 workers at the beginning of the project. The average salary for engineers and managers is $40,000 for the first year and average wage for workers is $25,000 for the first year. Both salaries and wages will increase at a constant rate of 10%. The contracts signed with 10 of the engineers and managers are for four years. Starting from year 4, each year 20 workers will be transferred to other mines. The variable cost (excluding wages and salaries) for producing gold is $1.5 per ounce.
The machines will be depreciated by MACRS. According to MT Environment Protection Law, the mine must restore the site to its original environment condition. It is estimated that the cost of restoration will be $1.5 million. When the restoration is finished, the government will return $2 million of environmental fee.
The current price of gold is $300 per ounce. As for the gold price by the time when the project starts, there are three different opinions about the gold price in the future. Most people believe the price will remain the same as the present price. Optimists believe that the gold price will increase 10% while pessimists predict that gold price will further decline by 5%. MTMC is in the 35% tax bracket.
Now you are hired as CFO of MTMC. Mr. Hunter is asking you to make a project analysis and make a presentation to the board of directors within a week.
QUESTION: Should this project be accepted and why?