Capital investment decision

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…