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Case 2 – Capital Investment Decisions 

Bethesda  Mining is a midsized coal mining company with 20 mines located in Ohio,  Pennsylvania, West Virginia, and Kentucky. The company operates deep  mines as well as strip mines. Most of the coal mined is sold under  contract, with excess production sold on the spot market. 

The coal  mining industry, especially high-sulfur coal operations such as  Bethesda, has been hard-hit by environmental regulations. Recently,  however, a combination of increased demand for coal and new pollution  reduction technologies has led to an improved market demand for  high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric  Company with a request to supply coal for its electric generators for  the next four years. Bethesda Mining does not have enough excess  capacity at its existing mines to guarantee the contract. The company is  considering opening a strip mine in Ohio on 5,000 acres of land  purchased 10 years ago for $5.4 million. Based on a recent appraisal,  the company feels it could receive $7.5 million on an aftertax basis if  it sold the land today. 

Strip  mining is a process where the layers of topsoil above a coal vein are  removed and the exposed coal is removed. Some time ago, the company  would remove the coal and leave the land in an unusable condition.  Changes in mining regulations now force a company to reclaim the land;  that is, when the mining is completed, the land must be restored to near  its original condition. The land can then be used for other purposes.  As they are currently operating at full capacity, Bethesda will need to  purchase additional equipment, which will cost $65 million. The  equipment will be depreciated on a seven-year MACRS schedule. The  contract only runs for four years. At that time, the coal from the site  will be entirely mined. The company feels that the equipment can be sold  for 60 percent of its initial purchase price. However, Bethesda plans  to open another strip mine at that time and will use the equipment at  the new mine. 

The  contract calls for the delivery of 500,000 tons of coal per year at a  price of $84 per ton. Bethesda Mining feels that coal production will be  750,000 tons, 810,000 tons, 830,000 tons, and 720,000 tons,  respectively, over the next four years. The excess production will be  sold in the spot market at an average of $95 per ton. Variable costs  amount to $43 per ton and fixed costs are $5.2 million per year. The  mine will require a net working capital investment of 5 percent of  sales. The NWC will be built up in the year prior to the sales. 

Bethesda  will be responsible for reclaiming the land at termination of the  mining. This will occur in Year 5. The company uses an outside company  for reclamation of all the company’s strip mines. It is estimated the  cost of reclamation will be $5.4 million. After the land is reclaimed,  the company plans to donate the land to the state for use as a public  park and recreation area as a condition to receive the necessary mining  permits. This will occur in Year 5 and result in a charitable expense  deduction of $7.5 million. Bethesda has a 21 percent tax rate and a  required return of 12 percent on new strip mine projects. Assume a loss  in any year will result in a tax credit. 

Assignment Directions

Write  a case analysis

You have  been approached by the president of the company with a request to  analyze the project. Define, calculate, discuss, and use decision  criteria to assess the investment using the following methods: 

1. Payback period.    
2. Profitability index  
3. Net present value 
4. Internal rate of return   

Based on  your analysis, should Bethesda Mining take the contract and open the  mine? In your analysis, discuss the advantages and disadvantages of  using each method for capital investment decisions. Discuss any other  capital investment techniques that you would use to help you make a more  informed decision. Are there any other variables that they should  consider in their decision?