Question

Hickock Mining is evaluating when to open a gold mine. The mine has 39,200 ounces of gold left that can be mined, and mining operations will produce 5,600 ounces per year. The required return on the gold mine is 10 percent, and it will cost $33.6 million to open the mine. When the mine is opened, the company will sign a contract that will guarantee the price of gold for the remaining life of the mine. If the mine is opened today, each ounce of gold will generate an aftertax cash flow of $1,360 per ounce. If the company waits one year, there is a 55 percent probability that the contract price will generate an aftertax cash flow of $1,560 per ounce and a 45 percent probability that the aftertax cash flow will be $1,260 per ounce. What is the value of the option to wait?

Answer 1

Value of the option to wait = $1,294,840

Step-by-step explanation:

Gold = 39,200 ounces

Production per Year = 5,600 ounces

Total production in Years = 39,200/5,600= 7

Required Rate Return = 10%

Initial cost =$33,600,000

• If the mine has been started today

After tax cash flow in a year = $1,360* 5,600 = $7,616,000

Net Present Value = - $33,600,000 + $7,616,000*PVIFA(10%, 7 Years)

= - $33,600,000 + $7,616,000*4.8684 = $3,477,73

• If the mine will be started next year

Expected after tax cash flow = $1,560*55%+$1,260*45% = $1,425/OUNCE

After tax cash flow in a year = $1,425 * 5,600 = $7,980,000

Net Present Value after 1 Year= - $33,600,000 + $7,980,000*PVIFA(10%, 7 Years)

= - $33,600,000 + $7,980,000*4.8684 = $5,249,832

NPV = $5,249,832 / 1.10 = $4,772.575

Option to wait = $4,772,575 - $3,477,734 = $1,294,840