Question

Keystone Energy Company is considering a $30 million investment in a Pennsylvania coal mine. Mining engineers estimate that the mine contains 7,500,000 tons of commercial-grade, economically minable coal. (Note: 1 U.S. "short" ton = 2,000 pounds). The percentage depletion allowance for coal is 10%. The market price for this coal is expected to be $60 per short ton in the first year of mining, escalating at an annual rate of 3% thereafter. Mining would commence immediately after the company’s investment. Keystone’s after-tax MARR is 15% per year, and its effective income tax rate is 35%. Keystone expects to mine and sell 500,000 short tons of coal each year for the life of the mine. The company expects its production expenses, exclusive of depletion deductions, will be approximately $45 per short ton in the first year of mining, escalating at an annual rate of 3% thereafter. Keystone will determine its depletion deduction using either the percentage depletion method or the cost depletion method, whichever is more favorable. One depletion method will be used for the life of the project (i.e., the methodology will not change during the course of the project). Determine the PW and IRR of the after-tax cash flow for this mining project. Is it a worthwhile undertaking?

Answer 1

The question involves evaluating the financial viability of Keystone Energy Company's potential coal mine investment in Pennsylvania. By calculating the project's PW and IRR, considering tax rates, depletion deductions, market price, and cost escalation rates, one can determine if the investment is worth pursuing.

Step-by-step explanation:

The question relates to the evaluation of a mining project's financial viability using Present Worth (PW) and Internal Rate of Return (IRR) methods, incorporating the percentage depletion allowance. The mining project entails Keystone Energy Company considering a $30 million investment in a Pennsylvania coal mine, with expectations to mine and sell 500,000 short tons of coal annually at an escalating market price and cost. Important project details include a 35% effective income tax rate, a 10% percentage depletion allowance, and an after-tax Minimum Acceptable Rate of Return (MARR) of 15%.

Key financial metrics such as PW and IRR must be calculated, taking into account the escalation rates of market price and cost as well as the depletion allowance method. The decision on pursuing the investment depends on these metrics' alignment with the company's financial benchmarks. The expected market price of $60 per short ton with a 3% escalation rate contrasts with production expenses of $45 per short ton, escalating at the same rate. The depletion deduction is a notable aspect of the calculation, impacting the project's after-tax cash flows.