Reference no: EM133069913

Question - Eastern Shallow, Ltd., is a mining company that operates a single gold mine, along with several other natural resource extraction ventures. The present price of gold is $300 per ounce and it costs the company $250 per ounce to produce the gold. Last year, 50,000 ounces of gold were produced. Engineers estimate that, at this rate of production, the mine will be exhausted in seven years. The firm's required rate of return on gold mining is 10%.

Assume that you are employed in the Finance Department at Eastern Shallow, Ltd.  The firm's owner, Ed Andrews, has recently taken an interest in "real options" analysis, and believes it to be particularly suited to natural resource extraction, and gold mining, in particular.  Ed has asked you to complete a "real options" analysis for him on the firm's gold mine.

Based on this information provided above, please answer the following questions:

1. What is the value at t = 0 of Eastern Shallow's gold mine?

2. Assume that inflation is expected to increase the cost of producing gold by 10% per year, for each year that the gold mine is in operation.  However, the market price of gold is not expected to increase above its current $300 per ounce level, due to large amounts of stockpiled gold available. Also, due to the high expected inflation rate, assume that the required rate of return for the firm's gold mine increases to 20%. Based on this information, calculate the estimated value of the gold mine at t = 0.

3. Suppose that Eastern Shallow, Ltd., may choose to close, re-open, or abandon the gold mine in response to fluctuations in the market price of gold. Can the "Net Present Value" (NPV) method be used to value the gold mine under these conditions?  Please describe.

4. After completing your analysis described above, what recommendation(s) would you make to Ed Andrews, the owner of Eastern Shallow, Ltd., about effectively managing the firm's gold mine during its expected useful life?