Question

This questions concerns the potential purchase of a copper mine for $100 million. The purchase would occur in Year 0, and copper production would commence in Year 1. You may assume that the copper mine produces a constant amount of copper each year forever. In this question, use a discount rate of 10%. Note that this questions has three parts.

Part A (12 points): Suppose that operating profits for the copper mine would be $25 million per year in Years 1 and 2. In Year 3, however, there is a 50% chance that the copper market will go into decline, and operating profits would fall permanently to -$15 million per year and a 50% chance that operating profits would remain permanently at $25 million per year. Calculate the expected value of the NPV of the copper mine, assuming that you would have to continue production forever.

(Hint: to calculate the NPV, first calculate the perpetuity value of profits starting in Year 3, and discount that value back to year zero)

Part B (12 points): Now suppose that you had the option to abandon the mine in Year 3 if the copper market went into permanent decline. If you abandon the mine, operating profits are $0 for Year 3 and beyond (assume that if you decide to abandon the mine you can never re-open it). Calculate the expected value of the NPV of the copper mine, assuming that you have the option to abandon the mine in Year 3.

Part C (6 points): If you have the option to abandon the mine, would it be a good purchase today? Explain your reasoning.

Answer 1