Question

6. You own a coal mining company and are considering opening a new mine. The mine will cost $120.0 million to open. If this money is spent immediately, the mine will generate $20.0 million for the next 10 years. After that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost $2.0 million per year in perpetuity. What does the IRR rule say about whether you should accept this opportunity

Answer 1

Answer:

What does the IRR rule say about whether you should accept this opportunity?

The IRR rule basically states that if the project's internal rate of return (IRR) is higher than the cost of capital (discount rate or WACC), then the project should be accepted. In this case, we are not given the company's WACC or any discount rate we can use, therefore there is nothing to compare the project's IRR against.

Based on prior experience, this project's IRR will not be very high and if we consider the cost of keeping the site clean forever, I really doubt that the project is profitable. If you calculate the project's IRR without including the perpetual cleaning cost, IRR = 11%.

If we assume any of the 3 WACCs I used as an example below, the project's IRR including cleaning costs:

• if WACC = 12%, then IRR = 9.26% REJECTED
• if WACC = 10%, then IRR = 8.98% REJECTED
• if WACC = 9%, then IRR = 8.79% REJECTED
• if WACC = 8%, then IRR = 8.54% ACCEPTED

In order for this project to be profitable, the WACC would need to be very low (around 8% or less).

Explanation:

cost of opening a new mine $120 million

annual cash flow $20 million

expected cleaning costs $2 per year in perpetuity

the cost of keeping the site clean forever = $2 million / discount rate or WACC:

• if WACC = 12%, then perpetual cost = $16.67 million
• if WACC = 10%, then perpetual cost = $20 million
• if WACC = 9%, then perpetual cost = $22.22 million
• if WACC = 8%, then perpetual cost = $25 million