Problem
Chapter 18 Mini Case (p.475): Strik-IT-Rich Gold Mining Company
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so, you will need to purchase land that your geologists believe to be rich in gold. Strik-it-Rich's management believes the expansion will allow it to mine and sell an additional 2,000 troy ounces of gold per year. The expansion, including the cost of the land, will cost $2,500,000. The current price of gold bullion is $1,400 per ounce and one-year gold futures are trading at $1,484 = $1,400 (1.06). Extraction costs are $1,050 per ounce.
The company's cost of capital is 10%. At the current gold price, the expansion looks profitable: NPV = ($1,400 - 1,050) x 2,000 / .10 - $2,500,000 = $4,500,000. However, Strik-it-Rich's management is concerned that large sales of gold reserves by Russia and the UK will drive the price of gold down to $1,100 for the foreseeable future. On the other hand, management believes that there is some possibility that the world will soon return to a gold reserve international monetary system. In the latter case, the price of gold would increase to at least $1,600 per ounce. The course of the future price of gold bullion should become clear in a year. Strik-it-Rich can postpone the expansion for a year by purchasing a call option on the land for $250,000.
A. What should Strik-it-Rich management do? Include in your discussion an analysis of how NPV would be affected if the price of gold increased or decreased significantly.
B. Is it a good idea to buy a call option on land? Why or why not?