Question

BHP is considering buying in a new iron ore mine which is forecasted to start earning $5,000,000 of revenue in the second year of operation. Revenue is projected to increase at 10% p.a., operating costs are 25% of annual revenue and the mine is kept for 3 years of revenue, after which it is expected to be sold for $5mil.

Setting up the mine requires $2mil today and $4mil in the first year. 60% of BHPs capital is financed through debt which has a cost of 8% and shareholders expect a 14% return on their equity. Does the new iron ore mine add to shareholders wealth? Use NPV and IRR to justify your answer.

Answer 1

We will keep the mine for a total of 4 years (3 years of revenue) and sell it at the end of the 4 years. The profit in the second year will be = 5 - 5 x 0.25 = 3.75 million which will increase at 10% for two more years. Hence, the profits will be = 3.75, 3.75 x 1.1 = 4.125, 3.75 x 1.1^2 = 4.5375.

Hence, the cash flows from year 0 will be = -2, -4, 3.75, 4.125, 9.5375

The total cost of capital will be = 0.6 x 8 + 0.4 x 14 = 10.4%.

Hence, the NPV will be = - 2 - 4/1.104 + 3.75/1.104^2 + 4.125/1.104^3 + 9.5375/1.104^4 = 6.9395 million.

Since NPV is positive, we should accept the project by the NPV method.

Let the IRR be R. Writing the IRR equation, we have

-2 - 4/(1+R) + 3.75/(1+R)^2 + 4.125/(1+R)^3 + 9.5375/(1+R)^4 = 0

R = 51.397%

Since the irr is more than the cost of capital, we should accept the project.