Determine the net present value-discount cash flows, Corporate Finance

Suppose GeKay Inc. has a two-year lease over a small copper deposit; the government acquires all rights to the property at the end of the lease.  It is known that the deposit contains eight million pounds of copper. Mining would involve a one-year development phase that would have an immediate (t=0) cost of $1.25 million.  

At the end of the development phase (at t=1), if GeKay decides to continue and mine the copper, GeKay would then pay all its extraction costs to a subcontractor, in advance, at a rate of 85 cents per pound (8 million pounds).

This amounts to a cash payment of $6.8 million one year from now (at t=1).  GeKay would also then (at t=1) sell the rights to the copper to be recovered (8 million pounds) to a third party at the spot price of copper at that time.  Copper prices follow a process such that percentage price changes are normally distributed with mean 7% and standard deviation 20%; the current price is .95 cents per pound.

The required return for copper mining projects is 10% and the riskless rate of interest (continuously compounded) is 5%.

Determine thenet present valueNPVof GeKay's potential $1.25m mining venture with standard Discount Cash Flows (DCF) analysis and compare it to the NPV from Real Options analysis.

Posted Date: 4/5/2013 5:26:57 AM | Location : United States

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