INVESTMENT DECISIONS UNDER UNCERTAINTY Peru Resources Maxine Peru, the CEO of Peru Resources was absorbed by the report

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INVESTMENT DECISIONS UNDER UNCERTAINTY
Peru Resources
Maxine Peru, the CEO of Peru Resources was absorbed by the
report handed to her as she entered the executive dining room.The
report described a proposed new mine on the North Ridge of
Mt.Zircon.A vein of transcendental zirconium (TZ) ore has
been discovered there on land owned by Mrs.Peru’s company.Test
borings indicated sufficient reserves to produce 340 tons per year
of TZ over a 7 year period.The vein probably also contained
hydrated zircon gemstones.The amount and quality of these zircons
were hard to predict,since they tended to occur in
“pockets”.The new mine 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 higher quality hydrated zircon
gemstones was $3,300 per pound.
Peru resources was a family-owned business with total assets of
$45 million.The outlay required for the new mine would be a major
commitment.Fortunately, Peru Resources was conservatively
financed,and Mrs.Peru believed that the company could borrow up to
$9 million at an interest rate of 8%.
The mine’s operating costs were projected at $900,000 per year,
including $400,000 of fixed costs and $500,000 of variable
costs.Mrs.Peru thought these forecasts were accurate.The big
question marks seemed to be the initial cost of the mine and the
selling price of TZ.
Opening the mine ,and providing the necessary machinery and
ore-crunching facilities,was supposed to cost $10 million, but cost
overruns of 15% was common in the mining business.In addition,new
environmental regulations,if enacted,could increase the cost of the
mine by $1.5 million.
There was a cheaper design for the mine,which would reduce its
cost by $1.7 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 $850,000 per
year at planned production levels.
The current price of transcendental zirconium was $10,000
per ton but there was no consensus on the future prices.Some
optimistic experts were projecting rapid price increases to as much
as $14,000 per ton in addition to an initial investment drop
of 20% and no environmental costs.On the other hand, there were
pessimists saying that prices could be as low as $7,500 per
ton.Mrs.Peru did not have strong views either way .Her best guess
was that price would just increase with inflation at about 3.5 %
per year.(Mine operating costs would also increase with
inflation)
Mrs.Peru had wide experience in the mining business ,and she
knew that investors in similar projects usually wanted a forecast
nominal rate of return of at least 14%.Tax rate is 35% and straight
line depreciation is used.
Conduct a sensitivity analysis for TZ price and initial cost
variables,for the base –case (expensive design) using the following
assumptions:
3.a Pessimistic scenarios:
3.a.1.1.Initial cost: 15% cost overrun combined with
environmental regulation
costs
of 1.5 million.
3.a1.1.2 25% drop in price
b. Optimistic scenarios:
3.b.1 20% initial cost reduction (and no environmental regulation
costs)
3.b.2. TZ Price =$14,000