Nadine Heru, the CEO of Heru Resources, hardly noticed the time as she was reviewing the engineering report just handed to her.
The report described a proposed new mine on the North Ridge of Mt. Diamond. A vein of zirconium ore had been discovered there on land owned by Ms. Heru’s company. Test borings indicated sufficient reserves to produce 340 tons per year of zirconium over a 7-year period. The vein probably also contained hydrated zircon gemstones. The amount and quality of these zircons 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 zircon gemstones was$3,300 per pound.
Heru 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, Heru Resources was conservatively financed, and Ms. Heru believed that the company could borrow up to $9 million at an interest rate of about 8 percent. The mine’s operating costs were projected at $900,000 per year, including $400,000 of fixed costs and $500,000 of variable costs. Ms. Heru thought these forecasts were accurate. The big question marks seemed to be the initial cost of the mine and the selling price of zirconium.
Opening the mine, and providing the necessary machinery and ore crunching facilities, was supposed to cost $10 million. There was a cheaper design for the mine, which would reduce its cost by $1.7 million. 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 zirconium was $10,000 per ton, but there was no consensus about future prices. 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. Ms. Heru did not have strong views either way: her best guess was that price would just increase with inflation at about 3.5 percent per year. (Mine operating costs would also increase with inflation.) Ms. Heru had wide experience in the mining business, and she knew that investors in similar projects usually wanted a forecasted nominal rate of return of at least 14 percent.
You have been asked to assist Ms. Heru in evaluating this project. Lay out the base-case NPV and IRR analysis and undertake sensitivity, or scenario analyses as appropriate. Assume that Heru Resources pays tax at a 35 percent rate. For simplicity, also assume that the investment in the mine could be depreciated for tax purposes straight-line over 7 years.
The Challenge
You have been hired as a consultant to advise Heru Resources on the opening of a new mine. The attached spreadsheet should be used to calculate the projections based on the details of the case. There are two sets of financials, side by side, so you can complete a comparison using different variable. You can manipulate the information in the green input cells to adjust projections to the income statement. You will need to create formulas to calculate the NPV and IRR calculations.
The sheet is not protected, so you can see the formulas. Use the spreadsheet and any other resources you would like to complete the following:
1. What is the NPV and IRR of the base scenario? (1
2. Which scenario is a better financial decision for the company; pay a higher opening cost and lower operating expenses, or pay a lower opening and higher operating costs?
3. Looking at the base scenario, at what discount rate is the project feasible? What information did you use to determine the rate?
4. Open the Best Case Scenario, and Worst Case Scenario tabs on this sheet. Complete the spreadsheet using information from the case to complete each. How does each scenario effect the decision to open the mine? What factor makes the biggest impact on the financial Analysis? )
5. Given your analysis, would you choose to open the mine? Why or why not?
