Question

After discovering a new gold vein in the Colorado Mountains, CTC Mining Corp must decide whether to go ahead and develop the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that could result in environmental damage. Before proceeding with the extraction, CTC must spend $1,200,000 for new mining equipment and pay $200,000 for its installation. The gold mined will net the firm an estimated $375,000 each year for the 5-year life of the vein. CTC’s cost of capital is 12%. For the purposes of this problem, assume that the cash inflows occur at the end of the year.

1. What are the project’s NPV and IRR?
2. Should this project be undertaken if environmental impacts were not a consideration?
3. How should environmental effects be considered, or any other, project?

Answer 1

a. NPV : - $ 48,207.50

IRR : 10.60 %

b. No, since the NPV < 0

c. The environmental damage should be considered by deducting the cost of environmental damage from the expected cash flows, to conduct a more accurate and meaningful cost benefit analysis.

Workings:

Initial Investment = $ 1,200,000 + $ 200,000 = $ 1,400,000.

PVIFA _{12%, 5 years} = [ { 1 - ( 1 / 1 + r ) ⁿ } / r ] = [ { 1 - ( 1 / 1.12 ) ⁵ } / 0.12 ] = 3.60478

NPV = $ 375,000 x 3.60478 - $ 1,400,000 = - $ 48,207.50

PV factor for computation of IRR = $ 1,400,000 / $ 375,000 = 3.7333

The corresponding discount rate at 5 years is 10.60 %