Capital investment decision
Due to the
volatile nature of the Potash industry, my proposed capital investment for K +
S Group is to invest further in their ‘Plan B’. Salt products have so far
performed well for the company and are noted as providing much needed income
during the 2013 Potash crisis.
Research
online suggests a new site in the US could cost upwards of $25million dollars. Let’s
use this as a starting point. However, a larger mine in South America could
cost upwards of $90 million with the potential to offer much bigger returns.
Discounted
cash flow
KCQ: FCF = OI – ∆NOA, if we think of OI as being operating
cash flow (C) and investment in net operating assets (∆NOA) as being capital
outlays (I).
Discounted rate is 10%.
|
|
Option A
Arizona Salt Mine
|
Option B
South America Salt Mine
|
|
Original
cost
|
$25.0m
|
$90.0m
|
|
Estimated
life1
|
10 years
|
10 years
|
|
Annual ton production
|
1.6m
|
6.0m
|
|
Price per ton
|
$60
|
$60
|
|
Residual value
|
$1.6m
|
$6.0m
|
|
Estimated
future cash flows
|
|
|
|
2016
|
-15.4m
|
270m
|
|
2017
|
-5.8m
|
360m
|
|
2018
|
3.8m
|
360m
|
|
2019
|
9.6m
|
360m
|
|
2020
|
9.6m
|
360m
|
|
2021
|
9.6m
|
360m
|
|
2022
|
9.6m
|
360m
|
|
2023
|
9.6m
|
360m
|
|
2024
|
9.6m
|
360m
|
|
2025
|
9.6m
|
360m
|
|
2026
|
9.6m
|
360m
|
Residual value based on comparison
with a coal mine found online. Residual value for resource mining means the
land has less value when re-selling (depending on the depletion rate).
The investment would be made on 31
December 2015. The estimated future cash
flows are expected to be received on 31 December of each year.
The
operational income from Option A has the potential to generate 9.6 million. The
operational income from Option B has the potential to generate 360 million. This
is due to the sheer size of Option B and the ability to generate much higher
volumes of product.
The payback
period for Option A is 2 years. The payback period for Option B is 1 year.
NPV and IRR
Investopedia
(2016) defines Net Present Value (NPV) as ‘the difference between the present
value of cash inflows and the present value of cash outflows’.
If we
evaluate the NPV, it quickly becomes apparent that although the larger mine
presents a significant investment, it would be capable of returning the net investment
within the first year of operations. However, that is only considering the
initial purchase price of the properties and not the operational expenses.
KCQ: According to the Study Guide (Turner 2016), ‘an investment
returning an Internal Rate of Return (IRR) of 20% is better than an investment
returning an IRR of 14%’ (Chapter 8, p.10).
Option A has
returned an IRR of 7% and Option B has returned an IRR of 324%.
KCQ: The larger the positive amount of NPV
the greater the amount of added value for a firm; the larger the negative
amount of NPV, the greater the amount of value it would destroy for a firm.
Option A has
returned an NPV of -$5.82 and Option B has returned an NPV of $2040.23.
This is
pretty massive. It’s obvious that Option B is the winner here. However, I think I’ve severely underestimated
the cost of purchasing a large salt mine. LOL. Not sure if I’m also missing
something else in my calculations…
