Case Study Data
The following data relate to Geelong Mining Ltd.
Geelong Mining is considering undertaking a gold-mining project.
- The company has undertaken an environmental impact study into the project, at a cost of $2.75 million. This study has indicated that the project will meet the government's environmental regulations.
- The project will last for 5 years.
- The project will require the purchase of new equipment at a cost of $7 million. This equipment will be depreciated to a book value of zero. The company has the option of using straight-line depreciation or diminishing value depreciation.
- The mine will produce 65,000 ounces of gold in its first year. This will then decline by 9,000 ounces per year, as the resource is depleted, so that it will only be producing 29,000 ounces in the fifth year.
- The cost of gold is expected to remain constant at $111 per ounce over the life of the project.
- Incremental costs, equal to 49% of incremental revenue, will be incurred each year of the project.
- Clean-up costs of $2.6 million will be incurred after the end of the project (i.e. in the 6th year).
- The mining equipment is expected to have a salvage value of $2.9 million.
- The project will require additional net working capital of $5.7 million. This will be recovered in full after the completion of the project.
Geelong Mining has the following items on the Liabilities & Equity side of its balance sheet:
- Preference Shares
o There are 2 million preference shares on issue
o These preference shares are currently trading at a price of $11.20
o They pay an annual dividend of $0.66
- Ordinary Shares
o There are 6 million ordinary shares on issue
o These shares have a beta of 1.4
o They are expected to pay a dividend of $2.53 next year
o This dividend is expected to grow at a rate of 6.4% until the dividend in Year 3, and then at a rate of 3.8% in perpetuity
- Corporate Bonds
o The bonds have a total face value of $12 million
o They mature in 7 years
o They pay an annual coupon payment at a coupon rate of 5.2% p.a.
o The company's bond yield is 4.12%.
Additional data
- The historical market risk premium is 4.6%
- The corporate tax rate is 30%
- The current yield on 10-year Australian Treasury Bonds is 3.47% in the most recent month
Case Study Questions
1. Determine the company's Weighted Average Cost of Capital.
2. Determine the NPV of the project.
(a) Use the company's WACC as the discount rate. However, explain any assumptions you are explicitly making by using the company's overall WACC in this way.
(b) Indicate which depreciation method you have used, and explain why you chose this method.
(c) If you have omitted any of the costs associated with the project from your analysis, explain why you have done so.
3. Should the company proceed with the project? Explain your answer.