BETHESDA MINING COMPANY

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

The coal mining industry, especially high-sulfur coal operationssuch as Bethesda, has been hard-hit by environmental regulations.Recently, however, a combination of increased demand for coal andnew pollution reduction technologies has led to an improved marketdemand for high-sulfur coal. Bethesda has just been approached byMid-Ohio Electric Company with a request to supply coal for itselectric generators for the next four years. Bethesda Mining doesnot have enough excess capacity at its existing mines to guaranteethe contract. The company is considering opening a strip mine inOhio on 5,000 acres of land purchased 10 years ago for $4 million.Based on a recent appraisal, the company feels it could receive$6.5 million on an aftertax basis if it sold the land today.

Strip mining is a process where the layers of topsoil above acoal vein are removed and the exposed coal is removed. Some timeago, the company would simply remove the coal and leave the land inan unusable condition. Changes in mining regulations now force acompany to reclaim the land; that is, when the mining is completed,the land must be restored to near its original condition. The landcan then be used for other purposes. Because it is currentlyoperating at full capacity, Bethesda will need to purchaseadditional necessary equipment, which will cost $95 million. Theequipment will be depreciated on a seven-year MACRS schedule. Thecontract runs for only four years. At that time the coal from thesite will be entirely mined. The company feels that the equipmentcan be sold for 60 percent of its initial purchase price in fouryears. However, Bethesda plans to open another strip mine at thattime and will use the equipment at the new mine.

The contract calls for the delivery of 500,000 tons of coal peryear at a price of $86 per ton. Bethesda Mining feels that coalproduction will be 620,000 tons, 680,000 tons, 730,000 tons, and590,000 tons, respectively, over the next four years. The excessproduction will be sold in the spot market at an average of $77 perton. Variable costs amount to $31 per ton, and fixed costs are$4,100,000 per year. The mine will require a net working capitalinvestment of 5 percent of sales. The NWC will be built up in theyear prior to the sales.

Bethesda will be responsible for reclaiming the land attermination of the mining. This will occur in Year 5. The companyuses an outside company for reclamation of all the company’s stripmines. It is estimated the cost of reclamation will be $2.7million. In order to get the necessary permits for the strip mine,the company agreed to donate the land after reclamation to thestate for use as a public park and recreation area. This will occurin Year 6 and result in a charitable expense deduction of $6million. Bethesda faces a 38 percent tax rate and has a 12 percentrequired return on new strip mine projects. Assume that a loss inany year will result in a tax credit.

You have been approached by the president of the company with arequest to analyze the project. Calculate the payback period,profitability index, net present value, and internal rate of returnfor the new strip mine. Should Bethesda Mining take the contractand open the mine?