Bethesda Case Project Capital Budgeting and Analysis
MBAC 6060 – Spring 2011
David M. Gross, Ph.D.
Bethesda Case – Project Capital Budgeting and Analysis
This assignment is due at the beginning of class on Tuesday March 29. Late assignments will not be accepted.
The goal of the case is to produce a capital budgeting model and use that model to test input assumptions and perform a simple real-option analysis. What follows is a slight modification and extension of the “Bethesda Mining Company” case in the text book.
Please use these instructions and the spreadsheet template to produce a capital budget model for the mining project described below. Use the model to answer the questions that follow the description.
When finished, please rename your spreadsheet using group-members name that is first alphabetically email the spreadsheet to me at .
You must produce and email to me a correct, working model to receive credit for the case.
Company Background and Project Information:
Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is sold under contract, with excess production sold on the spot market.
The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company feels it could receive $7 million on an after-tax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. Because it is currently operating at full capacity, Bethesda will need to purchase additional necessary equipment, which will cost $85 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract runs for only four years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price in four years.
The contract calls for the delivery of 500,000 tons of coal per year at a price of $95 per ton. Bethesda Mining feels that coal production will be 620,000 tons, 680,000 tons, 730,000 tons, and 590,000 tons, respectively, over the next four years.
Use cell B13 in the spreadsheet as production sensitivity input. Initially set cell B13 equal to 100% and set cell G13 = B13*B9. Set cell H13 = B13*B10 and so on. This will allow us to use cell B13 to test the project’s risk relative to the production estimates. (See question #5 below.)
The excess production will be sold in the spot market at an average of $90 per ton. Variable costs amount to $31 per ton, and fixed costs are $4,300,000 per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales. For example, NWC at time zero will equal 5% of total year-one revenue.
Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in year 5. The company uses an outside company for reclamation of all the company's strip mines. It is estimated the cost of reclamation will be $2.8 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area. This will occur in year 6 and result in a charitable expense deduction of $7.5 million. Bethesda will be able to apply the charitable donation against other revenue, thus the tax savings will result in real cash savings. Also assume that a loss in any year will result in a tax credit applied against other income in that year.
Bethesda faces a 38 percent tax rate and has a 15 percent required return on new strip mine projects.
You have been approached by the president of the company with a request to analyze the project.
General Model Outputs:
1. Calculate the net present value and the internal rate of return for the project. Define the NPV and IRR and interpret the calculated values. Should Bethesda Mining take the contract and open the mine?
Sensitivity Analysis of Operating Estimates:
2. Consider the Bethesda’s contract to sell 500,000 tons of coal per year at $95 per ton. What happens to the project (the NPV) if Bethesda opens the mine but the buyer, for some reason, does not honor the contract and all the coal must be sold at the average spot market price of $90? Hint: Set up your model such that “Spot Units” in cells G16 through J16 equal the “Production Units” in row 13 less the “Contract Units” in row 15.
3. Still assume the contract is not honored (so all the coal must be sold at the average spot market price) and the average spot price of coal falls. Recalculate the NPV assuming no contract and a $1 decrease in the spot price of coal. Use this result to estimate the NPV break-even average spot market price of coal. Hint: Do this by first calculating the ΔNPV/ΔSpot Price.
4. Use the “Goal Seek” to perform the same calculation. Assume no contract. Calculate the NPV break-even average spot market price of coal. Hint: In the “Goal Seek” box, set cell B32 to zero by changing cell B16.
5. Assume again the contract will be honored (so reset your model to the initial settings). Next consider the production estimates. For simplicity reasons, we will assume the production for each year will vary from the estimates by the same amount. So we can use cell B13 for this analysis. Use Goal Seek to calculate the NPV break-even minimum percent of estimated production.
6. Now consider the operating costs. First use Goal Seek to calculate the NPV break-even variable cost per ton. Next use Goal Seek to calculate the NPV Break-even Annual Fixed Costs. Be sure to reset the model to the initial assumptions (and the original NPV) before each analysis.
7. The model has four operating variables:
· Revenue per unit (the average spot price per ton of coal)
· Units (the percentage of the estimated production)
· Variable Cost per Ton
· Annual Fixed Costs
Consider the initial estimates for these inputs relative to the break-even levels calculated above. For each variable calculate the percent difference between the initial estimate and the break-even value. To which of these operating estimates is the project most sensitive? To which is the project least sensitive?
Sensitivity Analysis of Capital Expenditure and Termination Estimates:
8. The company assumes the value of the equipment at time 4 will be 60 percent of it cost. How important is this estimate to the success of the project? What is the minimum percentage of the original value necessary for the project to break even? (Remember to reset your model after analyzing each variable.)
9. Repeat this for the Reclamation Costs. Again, how sensitive is this estimate to the success of the project?
10. Now consider the Charitable Contribution Value of the Land. Recall this creates a tax savings for the firm in year 5, which will be allocated against other taxable income in that year. How important is this estimated contribution value to the success of the project? (Note: The lowest this value can be is zero.)
Sensitivity Analysis of the Tax Rate and Require Return:
11. Calculate the NPV break-even tax rate. Comment on the importance of a increase in the corporate tax rate to the success of the project.
12. Calculate the NPV break-even required return. What is the name for this rate?
13. Consider the various sensitivity analyses you have just performed. Comment on the input estimate you believe to be most susceptible to error and its importance to the success of the project.
Scenario Analysis of Operating Estimates:
14. Upper and lower bound estimates for the four operating variables are as follows:
· Spot price of coal: plus or minus $8 per ton
· Production: plus or minus 10% of the production annual estimates
· Variable Costs: plus or minus $4 per ton
· Fixed Costs: plus or minus $700,000
Calculate the NPV and IRR for three scenarios:
· The “Best Case”
· The “Worst Case” assuming the contract to sell at 500,000 tons at $95 is honored
· The “Worst Case” assuming the contract not honored and all coal is sold at the spot price.
Hint: You may want to create copies of your model page and performing the scenario analyses on the copies.
Delaying the Project:
15. The company is also considering delaying the project in hopes of selling the coal for more money. Obviously many changes to the assumed input variable should be made when assessing the effects delaying a project, but for simplicity reasons, please consider only the spot market price of coal. In other words, assume all of the cost, termination, production and tax estimates do not change. But delaying the project will result in the loss of the sales contract, thus the entire production of coal will be sold at the average spot market price over the four years subsequent to the start of the project.
Forecasting the spot price of a commodity is difficult, so we will not do it. Instead, we will calculate the minimum increase in price necessary to make a delay better than starting now. So we will calculate the percent change in the spot price of coal necessary to make the decision yield a higher time-zero NPV.
For example, if the firm decides to delay one year and the spot price of coal does not change, the project’s NPV today will equal $9,798,914/(1.15)1 = $8,520,795. This is a $5,694,805 difference from the base-line NPV of $14,170,600. This is due to the loss of the sales contract and the additional year of discounting of the $9,798,914 NPV when the project starts at time one.
If the company does delay one year (and therefore loses the sales contract) then at an average spot price of $95.6707, the NPV at the start time will be $16,296,190 and the NPV at time zero will be $16,296,190/(1.15)1 = $14,170,600. Since this is equal to the base-line NPV, any average spot price above $95.6707 (a 6.30% increase in the spot price) means that there is a benefit to delaying the project one year.
Repeat this calculation if the delaying the project 2, 3 and 4 years. Calculate the minimum total and annualized percent change in the spot price of coal relative to the $90 current estimate necessary to create a benefit from delaying the project.
(Note that the delay analysis could have been combined with all of the above sensitivity and scenario analyses to produce richer results.)
16. Now assume this analysis took place in the beginning of February 2008. Use the coal price chart linked here (or any other data you can find) to determine what would have been the best choice for the project start time given what has happened to coal prices. (Ohio is part of the “North Appalachia” coal region.)
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