Question;Maxine Peru, the CEO of Peru Resources;hardly noticed the plate;of savory quenelles de brochet and the;glass of Corton Charlemagne ?94 on the table before her. She was absorbed by;the engineering report handed to her just as she entered the executive;dining room.;The;report described a proposed new mine on the North Ridge;of Mt. Zircon. A vein of transcendental;zirconium ore had been;discovered there on land owned by Ms.;Peru?s company. Test borings indicated sufficient reserves to produce 340 tons;per year of;transcendental zirconium over a 7-year;period.;The;vein probably also contained hydrated zircon gemstones.;The amount and quality of these zircons;were hard to predict, since;they tended to occur in ?pockets.? The new;mine might come;across one, two, or dozens of pockets. The;mining engineer guessed;that 150 pounds per year might be found.;The current price for;high-quality hydrated zircon gemstones was;$3,300 per pound.;Peru;Resources was a family-owned business with total assets;of $45 million, including cash reserves of;$4 million. The outlay;required for the new mine would be a major;commitment. Fortunately, Peru Resources was conservatively financed, and Ms.;Peru;believed that the company could borrow up;to $9 million at an;interest rate of about 8%.;The;mine?s operating costs were projected at $900,000 per year;including $400,000 of fixed costs and;$500,000 of variable costs.;Ms. Peru thought these forecasts were;accurate. The big question;marks seemed to be the initial cost of the;mine and the selling price;of transcendental zirconium.;Opening the mine, and providing the necessary;machinery and;ore-crunching facilities, was supposed to;cost $10 million, but cost;overruns of 10% or 15% were common in the;mining business. In;addition, new environmental regulations, if;enacted, could increase;the cost of the mine by $1.5 million.;There was a cheaper design for the mine, which;would reduce;its cost by $1.7 million and eliminate much;of the uncertainty;about cost overruns. Unfortunately, this;design would require much;higher fixed operating costs. Fixed costs;would increase to;$850,000 per year at planned production;levels.;The;current price of transcendental zirconium was $10,000 per;ton, but there was no consensus about;future prices.;8;Some;experts;were projecting rapid price increases to as;much as $14,000 per;ton. On the other hand, there were;pessimists saying that prices;could be as low as $7,500 per ton. Ms. Peru;did not have strong;views either way: Her best guess was that;price would just increase;with inflation at about 3.5% per year.;(Mine operating costs would;also increase with inflation.);Ms.;Peru had wide experience in the mining business, and she;knew that investors in similar projects;usually wanted a forecasted;nominal rate of return of at least 14%.;You;have been asked to assist Ms. Peru in evaluating this project. Lay out the;base-case NPV analysis, and undertake sensitivity;scenario, or break-even analyses as;appropriate. Assume that Peru;Resources pays tax at a 35% rate. For;simplicity, also assume that;the investment in the mine could be;depreciated for tax purposes;straight-line over 7 years.;What;forecasts or scenarios should worry Ms. Peru the most?;Where would additional information be most;helpful? Is there a;case for delaying construction of the new;mine?;8;There were no traded forward or futures;contracts on transcendental zirconium. See Chapter 24.;Brealey, Richard, Myers, Stewart, Marcus;Alan (2012-07-01). Fundamentals of Corporate Finance, 7th edition (McGraw-Hill/Irwin;Series in Finance, Insurance and Real Esta) (Page 315). McGraw-Hill Higher;Education -A. Kindle Edition.
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