Draw a decision tree to summarise the dilemma faced by HBP

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Reference no: EM132180112

Question - HBP Mining Ltd (HBP) currently operates an iron ore mine and has commissioned GB to determine whether to continue operating the mine or to abandon it. The price of iron ore is currently $55 per ton, with the mine producing 80,000 tons of iron ore per year and costing $5 million per year to operate. In its current state, the mine has enough iron ore to continue operating for 88 years. Shutting the mine down would require HBP to bringing the land up to environmental standards, which is expected to cost $5 million, however, HBP can transfer the mine to local government without shutting down and gain 2 million in year 1 (the transfer option is only available in year 1). Reopening the mine once it is shut down would be an impossibility given current environmental standards. HBP's risk management department believes that (given current economic conditions) the price of iron ore has an equal probability (1/3) of going up by 25%, staying the same and going down by 30% every year for the next three years. After three years, economic conditions will have stabilised so that the price of iron ore will remain constant for the remaining life of the mine. They have also estimated HBP's cost of capital to be 15%.

Please explain each calculation. How you determined figures in expected price formula.

1. Draw a decision tree to summarise the dilemma faced by HBP.

2. Calculate the NPV of continuing to operate the mine by working your way backwards through the tree and taking into account the option to abandon.

3. Based on your answer in (2), what should HBP do with the iron ore mine?

Reference no: EM132180112

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