MINI CASE STUDY (10 marks) Norriega Girlie, the CEO of Girlie Resources, hardly noticed the plate of Litapi and the glas

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MINI CASE STUDY (10 marks)
Norriega Girlie, the CEO of Girlie Resources, hardly noticed the
plate of Litapi and the glass Ilya on the table before her. She was
absorbed by the engineering report handed to her just as she
entered the executive dining room.
In the report, a proposed new Business on the North Zambezi banks.
A vein of Swift Soft Sands had been discovered there on land owned
by Ms. Girlie’s company. Test borings indicated sufficient reserves
to produce 340 tons per year of Soft Sands over a 7-year
period.
The Banks probably also contained hard Clay mud. The amount and
quality of the mud were hard to predict, since they tended to occur
in “pockets.” The new Business might come across one, two, or
dozens of pockets. The mining engineer guessed that 150 pounds per
year might be found. The current price for high-quality hard Clay
mud was K3,300 per pound.
Girlie Resources was a family-owned business with total assets of
K45 million, including cash reserves of K4 million. The outlay
required for the new business would be a major commitment.
Fortunately, Girlie Resources was conservatively financed, and Ms.
Girlie believed that the company could borrow up to K9 million at
an interest rate of about 8 percent.
The Business’s operating costs were projected at K900,000 per year,
including K400,000 of fixed costs and K500,000 of variable costs.
Ms. Girlie thought these forecasts were accurate. The big question
marks seemed to be the initial cost of the Business and the selling
price of transcendental zirconium.
Opening the Business, and providing the necessary machinery and
ore-crunching facilities, was supposed to cost K10 million, but
cost overruns of 10 percent or 15 percent were common in the mining
business. In addition, new environmental regulations, if enacted,
could increase the cost of the Business by K1.5 million.
There was a cheaper design for the Business, which would reduce its
cost by K1.7 million and eliminate much of the uncertainty about
cost overruns. Unfortunately, this design would require much higher
fixed operating costs. Fixed costs would increase to K850,000 per
year at planned production levels.
The current price of Soft Sands was K10,000 per ton, but there was
no consensus about future prices.1 Some experts were projecting
rapid price increases to as much as K14,000 per ton. On the other
hand, there were pessimists saying that prices could be as low as
K7,500 per ton. Ms. Girlie did not have strong views either way:
her best guess was that price would just increase with inflation at
about 3.5 percent per year. (Business operating costs would also
increase with inflation.)
Ms. Girlie had wide experience in the mining business, and she knew
that investors in similar projects usually wanted a forecasted
nominal rate of return of at least 14 percent.
You have been asked to assist Ms. Girlie in evaluating this
project.
Lay out the base-case NPV analysis and undertake sensitivity,
scenario, or break-even analyses as appropriate. Assume that Girlie
Resources pays tax at a 35 percent rate. For simplicity, also
assume that the investment in the Business could be depreciated for
tax purposes straight-line over 7 years.
(a) What forecasts or scenarios should worry Ms. Girlie the
most?
(b) Where would additional information be most helpful? Is there a
case for delaying construction of the new business?
There were no traded forward or futures contracts on transcendental
zirconium.