Fred Montigo, the CEO of Montigo Resources, was absorbed by the engineering report handed to him just as he entered the executive dining room.
The report described a proposed new mine on the East Ridge of Mt. Niobium. A vein of transcendental niobium ore had been discovered there on land owned by Mr. Montigo's company. Test borings indicated sufficient reserves to produce 340 tons per year of transcendental niobium over a 7-year period.
The vein probably also contained hydrated niobium gemstones. The amount and quality of these niobiums were hard to predict, since they tended to occur in "pockets." The new mine might come across one, two, or dozens of pockets. The mining engineer guessed that 150 pounds per year might be found. The current price for high-quality hydrated niobium gemstones was $3,300 per pound.
Montigo Resources was a family-owned business with total assets of $45 million, including cash reserves of $4 million. The outlay required for the new mine would be a major commitment. Fortunately, Montigo Resources was conservatively financed, and Mr. Montigo believed that the company could borrow up to $9 million at an interest rate of about 8%.
The mine's operating costs were projected at $900,000 per year, including $400,000 of fixed costs and $500,000 of variable costs. Mr. Montigo thought these forecasts were accurate. The big question marks seemed to be the initial cost of the mine and the selling price of transcendental niobium.
Opening the mine, and providing the necessary machinery and ore-crunching facilities, was supposed to cost $10 million, but cost overruns of 10% or 15% were common in the mining business. In addition, new environmental regulations, if enacted, could increase the cost of the mine by $1.5 million.
There was a cheaper design for the mine, which would reduce its cost by $1.7 million and eliminate much of the uncertainty about cost overruns. Unfortunately, this design would require much higher fixed operating costs. Fixed costs would increase to $850,000 per year at planned production levels.
The current price of transcendental niobium was $10,000 per ton, but there was no consensus about future prices.9 Some experts were projecting rapid price increases to as much as $14,000 per ton. On the other hand, there were pessimists saying that prices could be as low as $7,500 per ton. Mr. Montigo did not have strong views either way: him best guess was that price would just increase with inflation at about 3.5% per year. (Mine operating costs would also increase with inflation.)
Mr. Montigo had wide experience in the mining business, and he knew that investors in similar projects usually wanted a forecast nominal rate of return of at least 14%.
You have been asked to assist Mr. Montigo in evaluating this project. Lay out the base-case NPV analysis, and undertake sensitivity, scenario, or break-even analyses as appropriate. Assume that Montigo Resources pays tax at a 35% rate. For simplicity, also assume that the investment in the mine could be depreciated for tax purposes straight-line over 7 years.
In 2 - 3 paragraphs, answer the following questions based on the information above:
- What forecasts or scenarios should worry Mr. Montigo the most?
- Where would additional information be most helpful?
- Is there a case for delaying construction of the new mine?