Kemal Inawel

Marini
Pisqa Arisanti

Background on
Chapman Coal Corporation

SITUATION ANALYSIS
Graham made the following projections of the
investment cost for each operation

THE COST PROJECTIONS

Strip
Mining
Leasehold Invesment
Equipment
Additional Working
Capital Requirements
Total

Underground
Mining

400,000

300,000

3,000,000

1,500,000

200,000

200,000

3,600,000

2,000,000

 10 year life may be expected on either of the two prospective investments

The equipment would be depreciated over the same life on straight- line
basis over the life.
The projected Salvage Value for operation
Strip mining
= $600,000
Underground mining = $150,000
The recommended that the strip mining project be discounted at a 10%
Rate, while the underground mining proposal be analyzed with a 20%
criterion.
However the companys cost of capital had been computed to be 8%, so
head of engineering David Hughes believe that this should be the discount
rate used.
The Risk free rates is currently 6%.
The engineering personnel estimated the standard deviation relating to
the salvage value of each project:
Strip mining
= $ 300,000
Underground mining = $ 135,000

PROBLEM ANALYSIS
The two projects are mutually exclusive (only
one may be taken, or neither)
Graham would have to determine which
project would deliver the most profit at
present value

EARNINGS AFTER TAX

Years
Strip Mining

Underground
Mining

Annual expected
Earning After Taxes

Standard deviation of
Earning After Taxes

1-4

400,000

340,000

5-7

220,000

250,000

8-10

100,000

190,000

1-4

360,000

315,000

5-7

230,000

276,500

8-10

130,000

236,000

EXHIBIT 1
Chapman Coal Corporation
Management's Risk - Return Profile
Coefficient of Variation

Certainty Equivalent Factor

0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9

0.95
0.93
0.91
0.88
0.85
0.82
0.78
0.74
0.70
0.64
0.58
0.52
0.43
0.33
0.15

Certainty Equivalent Factor

1.00

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.00
0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

Method I: Certainty Equivalence

Years

Annual
Standard
expected
deviation of
Earning
Earning After
after Taxes
Taxes

Certainty
Coefficient
Expected
Equivalent
of variation
Cash Flow
Factor

1-4

400,000

340,000

0.85

5-7

220,000

250,000

1.14

0.865 346,000
0.760 167,200

8-10

100,000

190,000

1.90

0.150

Salvage Value( 10)

600,000

300,000

0.50

1-4

360,000

315,000

0.88

0.950 570,000
0.850 306,000

5-7

230,000

276,500

1.20

Underground 8-10
mining
Salvage Value( 10)

130,000

236,000

1.82

0.740 170,200
0.300 39,000

150,000

135,000

0.90

0.850 127,500

Strip Mining

15,000

Coefficient of Variation = Standard deviation of Earning After Taxes : Annual

expected Earning after Taxes
Expected Cash Flow = Annual expected Earning after Taxes x Certainty Equivalent
Factor

Strip Mining
Year
1
2
3
4
5
6
7
8
9
10

Expected Cash Flow

346,000
346,000
346,000
346,000
167,200
167,200
167,200
15,000
15,000
585,000

PV Factor at 6%
0.943
0.890
0.840
0.792
0.747
0.705
0.665
0.627
0.592
0.558
TOTAL NPV

By Certainty Equivalent Method

Present Value
326,415.09
307,938.77
290,508.27
274,064.41
124,941.57
117,869.40
111,197.55
9,411.19
8,878.48
326,660.94
1,897,885.67

By Certainty Equivalent Method

Underground Mining
Year
1
2
3
4
5
6
7
8
9
10

Expected Cash Flow

306,000
306,000
306,000
306,000
170,200
170,200
170,200
39,000
39,000
166,500

PV Factor at 6%
0.943
0.890
0.840
0.792
0.747
0.705
0.665
0.627
0.592
0.558
TOTAL NPV

Present Value
288,679.25
272,338.91
256,923.50
242,380.66
127,183.34
119,984.28
113,192.72
24,469.08
23,084.04
92,972.73
1,561,208.52

Method 2: Risk Adjusted

Years

Strip
Mining

Annual
expected
Earning after
Taxes

PV Factor
10%

PV

PV Factor 8%

PV

400,000

0.909

363,600

0.926

370,400

400,000

0.826

330,400

0.857

342,800

400,000

0.751

300,400

0.794

317,600

400,000

0.683

273,200

0.735

294,000

220,000

0.621

136,620

0.681

149,820

220,000

0.564

124,080

0.630

138,600

220,000

0.513

112,860

0.583

128,260

100,000

0.467

46,700

0.540

54,000

100,000

0.424

42,400

0.500

50,000

10

100,000

0.386

38,600

0.463

46,300

Salvage Value( 10)

600,000

0.386 231,600
TOTAL NVP 2,000,460

0.463

277,800

TOTAL NVP 2,169,580

By Risk Adjusted Method

Underground
Mining

Years

Annual
expected PV Factor
Earning after 20%
Taxes

360,000

0.833

299,880

0.926

333,360

360,000

0.694

249,840

0.857

308,520

360,000

0.579

208,440

0.794

285,840

360,000

0.482

173,520

0.735

264,600

230,000

0.402

92,460

0.681

156,630

230,000

0.335

77,050

0.630

144,900

230,000

0.279

64,170

0.583

134,090

130,000

0.233

30,290

0.540

70,200

130,000

0.194

25,220

0.500

65,000

10

130,000

0.162

21,060

0.463

60,190

Salvage Value( 10)

150,000

0.162

24,300

0.463

69,450

PV

PV Factor
8%

PV

TOTAL NVP 1,266,230 TOTAL NVP 1,892,780

Strip Mining
Underground
Mining

Investment Present Value

Profit /
PV By Risk Profit / PV By Risk
Profit /
Cost
By Certainty
(Deficit)
Adjusted
(Deficit)
Adjusted
(Deficit)
Equivalent
Method
Method
Method (6%)
(10%&20%)
(8%)
3,600,000 1,897,885.67 -1,702,114.33 2,000,460 -1,599,540 2,169,580 -1,430,420
2,000,000 1,561,208.52
-438,791.48 1,266,230
-733,770 1,892,780 -107,220

According to the calculation result, all the results are negative regardless of the
method and discount rate used (the investment cost > NVP)
Therefore we decided NOT to take either alternative, as they both will result in
a net loss

THE END