Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. Recently the coal mining industry has been impacted by environmental regulations that have presented challenges for the industry. However, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda is considering operating a new strip mine in Ohio on 5,000 acres of land it purchased 10 years ago for $5,300,000. Bethesda is currently operating at full capacity and if this project is undertaken will need to purchase additional equipment that will cost $34,000,000. The project will provide a four-year contract that calls for the delivery of 400,000 tons of coal per year at a price of $50 per ton. At the end of the mining at the site, Bethesda will be responsible for reclaiming the land. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area and receive a charitable expense deduction of $6,000,000.
The purpose of this paper is to analyze the project through calculating the payback period, profitability index, average accounting return, net present value, internal rate of return, and modified internal rate of return for the new strip mine. Based on these calculations, it will be determined whether Bethesda should take the contract and open the mine or pursue other opportunities. The Payback Period
The payback period method calculates the time it takes for a project to “pay back” its initial investment. The period is usually reflected in terms of number of years. Management sets the minimum acceptance criteria for how long it feels appropriate for the project to take before it starts paying for itself. The advantages to this method are that it is easy to understand and is biased towards liquidity. The disadvantages to this method are that it ignores the time value of money and cash flows after the payback period, it is biased against long-term projects, requires arbitrary acceptance criteria, and may lead to an acceptable project that has a negative net present value.
The payback period for the project Bethesda is considering is 3.03 years*. This means it will take the project just over three years for the company to receive its initial investment back. As stated above, the minimum time period will have to be set by management within Bethesda. It is clear, however, that this project does pay for itself within the contracted timeframe, with most of year four being all profit. The Profitability Index
The profitability index is a ratio of the total present value of future cash flows for a project divided by its initial investment. A project should only be accepted with a value greater than one. The higher the profitability index ratio, the more attractive the project. The advantages of the profitability index are that it may be useful when available investment funds are limited, it is easy to understand and communicate, and it leads to the correct decision when evaluating independent projects. The main disadvantage with the index is that it presents problems with mutually exclusive investments.
The profitability index for the project Bethesda is considering is 1.23*. This value is greater than one, so the project appears attractive. However, this ratio should be compared to other investment opportunities and the project with the highest profitability index should be selected based on this criteria.
The Average Accounting Return
The average accounting return is the average net income divided by the average book value of the investment during its life. This ratio is helpful in analyzing how well investment assets are being used to generate income. One problem with the average accounting return is the fact that the inputs are affected by the accountant’s judgment. The judgment call...