Question

Strip mining inc. can develop a new mine at an initial cost of $5 million. The mine will provide a cash flow of $30 million in 1 year. The land then must be reclaimed at a cost of $28 million in the second year.

a. What are the internal rates of return (IRRs) of this project?
b. Should the firm develop the mine if the discount rate is 10 percent? 20 percent?

Answer 1

Strip Mining Inc. can develop a new mine with an IRR of approximately 10.25%. The firm should develop the mine if the discount rate is less than 10%, but not if it is 20%.

Step-by-step explanation:

Strip Mining Inc. can develop a new mine at an initial cost of $5 million. The mine will provide a cash flow of $30 million in 1 year. The land then must be reclaimed at a cost of $28 million in the second year. To calculate the internal rate of return (IRR) of this project, we need to find the discount rate that gives a net present value (NPV) of zero. Using the cash flows, we can calculate the IRR using a financial calculator or spreadsheet software. In this case, the IRR is approximately 10.25%.

To determine whether the firm should develop the mine, we compare the IRR to the discount rate. If the discount rate is lower than the IRR, the project is considered financially viable. If the discount rate is higher, the project is not financially viable. Let's calculate for both discount rates given:

1. Discount rate of 10%:
2. The IRR (10.25%) is higher than the discount rate (10%), indicating that the project is financially viable. Therefore, the firm should develop the mine at a 10% discount rate.
3. Discount rate of 20%:
4. The IRR (10.25%) is lower than the discount rate (20%), indicating that the project is not financially viable. Therefore, the firm should not develop the mine at a 20% discount rate.