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Complex Engineering Problem

Complex Engineering Problem

Application of capital budgeting Techniques for Gold Mine Project

Problem Statement

While drilling at 10500 ft deep well, a decrease in ROP has been experienced in “xyz” formation.
Drill off test (DOT) has been performed to optimize ROP. Currently drilling is going on with 8 3/8-
inch PDC drill bit at 10500 ft depth and the last casing of 9 5/8-inch was run at 9000 ft. premium
quality 5-inch drill pipes (ID = 4.276 inch) have been used having 9700 ft length and rest 800 ft,
6.5 inch-drill collars (ID = 2 13/16-inch) have been used. Mr. Z, the owner of ZB Gold Mining, is
evaluating a new gold mine in North Dakota. Mr. Q, the company’s geologist, has just finished his analysis
of the mine site. He has estimated that the mine would be productive for eight years, after which the gold
would be completely mined. Mr. Q has taken an estimate of the gold deposits to Mrs. G , the company’s
financial officer. Mrs. G has been asked by Mr. Z to perform an analysis of the new mine and present her
recommendation on whether the company should open the new mine. Mrs. G has used the estimates
provided by Q to determine the revenues that could be expected from the mine. She has also projected
the expense of opening the mine and the annual operating expenses. If the company opens the mine, it
will cost $600 million today, and it will have a cash outflow of $95 million nine years from today in costs
associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each
year from the mine are shown in the table. ZB Mining has a 12 percent required return on all of its gold
mines.
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Complex Engineering Problem

Objective(s)
Construct Spreadsheet to calculate

• Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Decide whether the company should open the mine.

Theory
Payback Period: The payback period, also referred to as the breakeven point, is defined as the
expected number of years required for recovering the original investment. At this point, the cash
receipts exactly equal the cash disbursements.

Calculation

• Mathematically:

• Graphically: Explained in solution

Net Present Value (NPV): The net present value (NPV), also referred to as the present value of cash
surplus or present worth, is obtained by subtracting the present value of periodic cash outflows from
the present value of periodic cash inflows. The present value is calculated using the weighted average
cost of capital of the investor, also referred to as the discount rate or minimum acceptable rate of
return. The discount rate should reflect the value of the alternative use of funds.

Calculation

• Mathematically:

• Excel Formula: Explained in solution

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Complex Engineering Problem

Internal rate of Return (IRR): Internal rate of return (IRR) is another important and widely reported
measure of profitability. IRR is reported as a percentage rather than a dollar figure such as NPV. The
internal rate of return (IRR) is also referred to as the discounted cash flow rate of return (DCFROR), rate
of return (ROR), internal yield, marginal efficiency of capital, and the investor’s method. IRR is the
discount rate at which the net present value is exactly equal to zero, or the present value of cash inflows
is equal to the present value of cash outflows.

Calculation

• Mathematically:

• Excel Formula: Explained in solution

• Graphically: Explained in solution

Modified Internal rate of Return (MIRR): Modified internal rate of return (MIRR) assumes that
positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the
firm's financing cost. By contrast, the traditional internal rate of return (IRR) assumes the cash flows
from a project are reinvested at the IRR. MIRR is also call Growth Rate of Return (GRR).

Modified internal rate of return is utilized where there is non-conventional cash flow. In such a case we
get two distinct internal rates of return.

Calculation

• Mathematically:

• Excel Formula: Explained in solution

• Graphically
Conventional Cash Flows: A conventional cash flow is one in which the initial capital investment
outlay is followed by a stream of positive net revenues of the form: – + + + + …..; or if the initial outlay
takes place over a number of years, the cash flow has the form: – – – + + + + . The cumulative net cash
flow of such conventional cash flows shows only one sign change from negative to positive.

Non-Conventional Cash Flows: Nonconventional cash flows are those that have more than one sign
change, such as + – – + + + or – + + + –. Many oil field investments may follow nonconventional cash
flows. The example is a non-conventional cash flow.
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Complex Engineering Problem

Solution

Payback Period
Payback period given by following formula

1
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = 4 + × −(−35) = 4.146 𝑦𝑒𝑎𝑟𝑠
205 − (−35)

Net Present Value (NPV)

Mathematically: Using formula

𝑁𝑃𝑉 = 83.26 𝑀$
Assumption: Mid-year Cash Flow. Calculations are done in spreadsheet.
Excel Formula: Excel has built in formula to calculate NPV demonstrated in spreadsheet
program.
= negative cash outflow + NPV (rate, values)
83.26+88.11
𝑁𝑃𝑉 = 88.11 𝑀$ 𝐴𝑣𝑔. 𝑁𝑃𝑉 = = 85.685𝑀$
2

Internal Rate of Return (IRR)

To calculate IRR, first we have to develop NPV profile at various discount rates. The NPV profile
for above example is developed in spreadsheet using excel formula NPV. Then,
Mathematically: using formula
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Complex Engineering Problem

Taking values from spreadsheet.

1
𝐼𝑅𝑅 = 1−(−19) (17 − 16) + 16) = 16.05%

Excel Formula: Excel has built in function for calculation of IRR as follow
=IRR (values of cash flow, initial guess IRR)
𝐼𝑅𝑅 = 16%
Graphically: IRR can be evaluated graphically by developing NPV profile, presenting it on graph
and then intersecting the point where the NPV = 0 and then dropping a co-ordinate down to
discount rate giving us IRR.

NPV Profile
600

500

400

300
NPV

200

100

-100
0% 5% 10% 15% 20% 25%
Discount Rate

𝐼𝑅𝑅 = 16.01%
16.02 + 16 + 16.01
𝐴𝑣𝑔. 𝐼𝑅𝑅 = = 16.01%
3
Although, all methods gave accurate and almost very similar results. Still we use average
because the average of all the methods gives best fit and last result.
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Complex Engineering Problem

Modified Internal Rate of Return (MIRR)

Mathematically: Using formula

Where PI = Profitability Index

So first, we will have to evaluate productivity Index using formula.
𝑁𝑃𝑉
𝑃𝐼 = 1 +
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
NPV = 85.685 M$
1
PV of capital investment = 600 + 95 [(1+0.12)9 ] = 635 𝑀$

85.685
𝑃𝐼 = 1 + = 1.14
635
1
𝑀𝐼𝑅𝑅 = 1.149 (1 + 0.12) − 1 × 100 = 13.65%
Excel Formula: Excel has built in function for calculation of MIRR as follow
=MIRR (Range of values of cash flow, initial guess id, reinvestment id)
𝑀𝐼𝑅𝑅 = 14%
13.65 + 14
𝐴𝑣𝑔. 𝑀𝐼𝑅𝑅 = = 13.825%
2

Results
Payback Period 4.146 Years
Net Present Value (NPV) 85.685 M$
Internal Rate of Return (IRR) 16.01%
Modified Internal Rate of Return (MIRR) 13.83%
• Payback period is 4 years which less than half the total tenure of project.
• NPV is positive which shows that after the outflows are balanced by inflows, still there is
an inflow of 85.685 M$. That is a Profit.
• IRR is 16% which is greater than 12% (required rate of return)
• MIRR is 13.685% greater than the required rate of return.
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Complex Engineering Problem

Conclusion
All the above results give us strong indication of return of good profit in return. The above 4
budgeting techniques used help us to be in strong favor of opening Gold Mine and we suggest
that The company should open Gold Mine with Good profit Returns.
Years Cash Flow Cumm. NCF t 1/(1+id)^t NPV @ NPV Profile Value Results
(M$) (M$) 12%
0 -600 -600 0.5 0.9449112 -566.94671 Discount NPV Mathematically Excel F.
rate
1 75 -525 1.5 0.8436707 63.2753024 0% 490 Payback 4.146 Years
Period
2 120 -405 2.5 0.7532774 90.3932891 2.00% 404 NPV 83.26 M$ 88.11
M$
Complex Engineering Problem

3 160 -245 3.5 0.6725691 107.611059 4.00% 326 IRR 16.02% 16%
4 210 -35 4.5 0.6005081 126.106709 6.00% 257 MIRR 13.63% 14%
5 240 205 5.5 0.536168 128.680315 8.00% 195
6 160 365 6.5 0.4787214 76.5954259 10.00% 139
7 130 495 7.5 0.4274298 55.5658782 12.00% 88
8 90 585 8.5 0.3816338 34.3470401 14.00% 42
9 -95 490 9.5 0.3407444 -32.370722 16.00% 1
18.00% -37
Total 490 83.257587 20.00% -71
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