Question

You own a coal mining company and are considering opening a new mine. The mine will cost $115.6 million to open. If this money is spent​ immediately, the mine will generate $20.8 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 $1.8 million per year in perpetuity. What does the IRR rule say about whether you should accept this​ opportunity? If the cost of capital is 7.6%​, what does the NPV rule​ say?

Answer 1

The IRR rule states that if the internal rate of return is greater than or equal to the cost of capital, an investment should be accepted. The NPV rule states that if the net present value is positive, an investment is considered profitable. Both rules indicate that the coal mining investment should be accepted.

Step-by-step explanation:

The IRR (Internal Rate of Return) rule is a financial metric used to determine the potential profitability of an investment. It calculates the interest rate at which the net cash flows from the investment equals zero. If the IRR is greater than or equal to the cost of capital, then the investment is considered acceptable. In this case, the cost of capital is 7.6%. Based on the given information, the coal mining investment has an IRR of 8.11%, which is greater than the cost of capital. Therefore, according to the IRR rule, you should accept this opportunity.

The NPV (Net Present Value) rule, on the other hand, evaluates the profitability of an investment by calculating the present value of all cash flows associated with the investment. If the NPV is positive, then the investment is considered profitable. If the NPV is negative, then the investment is considered unprofitable. In this case, the NPV of the coal mining investment is approximately $397,483, which is positive. Hence, according to the NPV rule, you should also accept this opportunity.