Maxine Peru, the CEO of Peru Resources, hardly noticed the plate

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.