Investment Decision

Module Lecturer: Marcus Davison

Individual Assignment

Eigentor Bergbau GmbH ('EB') is a private, owner-managed German mining company.  It is investigating the possibility of investing €5m in a licence to open and operate an open-cast coal mine on state-owned property in the Republic of Slovakia.  EB's surveyors and engineers have spent the last three months examining the potential of the mine and have incurred costs to date of €0.4m. The surveyors have prepared a report which states that the company will require equipment and vehicles costing €25m in order to operate the mine and that these assets can be sold for €5m in four years' time when the coal reserves of the mine are expected to be exhausted.

The assistant to the Chief Financial Officer of EB has prepared the following income statements (pre-tax, and on an accruals basis, not a cash basis) for each year of the life of the mine.  All amounts have been computed in nominal terms, i.e. they have been adjusted in line with expected inflation.

Projected Income Statements (€m)

	Year
	1	2	3	4
Sales	20.00	22.00	17.00	15.00
Wages and salaries	-4.60	-5.00	-5.20	-3.60
Selling and distribution costs	-2.60	-2.40	-3.00	-1.20
Materials and consumables	-0.60	-0.80	-0.80	-0.40
Depreciation	-6.25	-6.25	-6.25	-6.25
Head office expenses	-1.20	-1.20	-1.20	-1.20
Survey costs	-0.80
Interest expense	-2.40	-2.40	-2.40	-2.40
Net profit/(loss)	1.55	3.95	-1.85	-0.05

In his report to the Chief Financial Officer, the assistant recommends that the company should not proceed with the acquisition of the mine as the profitability of the proposal is poor.

The following additional information is available (albeit some of it might not be relevant to your task):

• The project will require an investment of €1.0m of working capital from the beginning of the project until the end of the useful life of the mine.

• The wages and salaries expense includes €1.0m in Year 1 for staff who are already employed by EB but who would be without productive work until Year 2 if the project does not proceed. However, the company has no intention of dismissing these staff.  After Year 1, these staff will be employed on another project of the company.

·         One-third of the head office expenses consist of amounts directly incurred in managing the new project and two-thirds represents an apportionment of other head office expenses to the project to ensure that it bears a fair share of these expenses.

• The survey costs include those costs already incurred to date, and which are to be written off in the first year of the project, as well as costs to be incurred in the first year if the project is accepted.

• The interest charges relate to finance required to purchase the equipment and vehicles necessary to carry out the project.

• After the mine has been exhausted, the company will be required to clean up the site and to make good the damage to the environment resulting from its mining operations. The company will incur costs of €0.8m in order to do this: these costs have not been taken into account in the draft Income Statement.

EB's corporate tax rate is 30%.  All operating income and expense is subject to tax at this rate.  Capital expenditure is tax-deductible in two equal annual instalments commencing in the year in which the expenditure is incurred, but a balancing charge will be payable in the event that the equipment is sold for more than its tax-depreciated value.  All taxes are paid one year after the end of the year to which they relate.  EB's owners have a target rate of return of 12% pa (in nominal terms) for mainstream projects, i.e. those projects having 'average' risk for the company.

Required:

1. Critically review the figures provided, and any assumptions on which they appear to have been based.

2. Prepare a DCF analysis of the project, including an appropriate sensitivity analysis.  Explain any additional assumptions that you have found it necessary or useful to make.

3. Make a provisional recommendation either to approve or reject the project, giving your reasons.

4. Describe briefly any other factors (i.e. any factors not explicitly take into account in the information provided above) that you think the company should consider when making its final decision.

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