Chapman Coal

Corporation

• Kemal Inawel• Marini• Pisqa Arisanti

Background on Chapman Coal Corporation

• On December 31, 1977 , The Chapman Coal Corporation was investigating the feasibility of 2 mutually exclusive Projects:1. Strip Mining2. Underground Mining• Gene Graham had been involved in the development of revenue and expense projections for the two projects.

SITUATION ANALYSIS

Strip Mining

Underground Mining

Leasehold Invesment 400,000 300,000Equipment 3,000,000 1,500,000Additional Working Capital Requirements

200,000 200,000

Total 3,600,000 2,000,000

Graham made the following projections of the investment cost for each operation

THE COST PROJECTIONS

• 10 year life may be expected on either of the two prospective investments• The equipment would be depreciated over the same life on straight- line

basis over the life.• The projected Salvage Value for operation

– Strip mining = $600,000– Underground mining = $150,000

• The recommended that the strip mining project be discounted at a 10% Rate, while the underground mining proposal be analyzed with a 20% criterion.

• However the company’s cost of capital had been computed to be 8%, so head of engineering David Hughes believe that this should be the discount rate used.

• The Risk free rates is currently 6%.• The engineering personnel estimated the standard deviation relating to the

salvage value of each project:– Strip mining = $ 300,000 – Underground mining = $ 135,000

PROBLEM ANALYSIS

• The two projects are mutually exclusive (only one may be taken, or neither)

• Graham would have to determine which project would deliver the most profit at present value

Years Annual expected Earning After Taxes

Standard deviation of Earning After Taxes

Strip Mining 1-4 400,000 340,0005-7 220,000 250,000

8-10 100,000 190,000Underground Mining

1-4 360,000 315,000

5-7 230,000 276,5008-10 130,000 236,000

EARNINGS AFTER TAX

EXHIBIT 1Chapman Coal Corporation

Management's Risk - Return ProfileCoefficient of Variation Certainty Equivalent Factor

0.5 0.950.6 0.930.7 0.910.8 0.880.9 0.851 0.82

1.1 0.781.2 0.741.3 0.701.4 0.641.5 0.581.6 0.521.7 0.431.8 0.331.9 0.15

0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.00.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Certainty Equivalent Factor

Years

Annual expected Earning

after Taxes

Standard deviation of

Earning After Taxes

Coefficient of variation

Certainty Equivalent

FactorExpected Cash Flow

Strip Mining

1-4 400,000 340,000 0.85 0.865 346,000

5-7 220,000 250,000 1.14 0.760 167,200

8-10 100,000 190,000 1.90 0.150 15,000

Salvage Value( 10) 600,000 300,000 0.50 0.950 570,000

Underground mining

1-4 360,000 315,000 0.88 0.850 306,000

5-7 230,000 276,500 1.20 0.740 170,200

8-10 130,000 236,000 1.82 0.300 39,000

Salvage Value( 10) 150,000 135,000 0.90 0.850 127,500

• Coefficient of Variation = Standard deviation of Earning After Taxes : Annual expected Earning after Taxes

• Expected Cash Flow = Annual expected Earning after Taxes x Certainty Equivalent Factor

Method I: Certainty Equivalence

Strip MiningYear Expected Cash Flow PV Factor at 6% Present Value

1 346,000 0.943 326,415.092 346,000 0.890 307,938.773 346,000 0.840 290,508.274 346,000 0.792 274,064.415 167,200 0.747 124,941.576 167,200 0.705 117,869.407 167,200 0.665 111,197.558 15,000 0.627 9,411.199 15,000 0.592 8,878.48

10 585,000 0.558 326,660.94TOTAL NPV 1,897,885.67

By Certainty Equivalent Method

Underground MiningYear Expected Cash Flow PV Factor at 6% Present Value

1 306,000 0.943 288,679.252 306,000 0.890 272,338.913 306,000 0.840 256,923.504 306,000 0.792 242,380.665 170,200 0.747 127,183.346 170,200 0.705 119,984.287 170,200 0.665 113,192.728 39,000 0.627 24,469.089 39,000 0.592 23,084.04

10 166,500 0.558 92,972.73TOTAL NPV 1,561,208.52

By Certainty Equivalent Method

Years

Annual expected

Earning after Taxes

PV Factor 10% PV PV Factor 8% PV

Strip Mining

1 400,000 0.909 363,600 0.926 370,400

2 400,000 0.826 330,400 0.857 342,800

3 400,000 0.751 300,400 0.794 317,600

4 400,000 0.683 273,200 0.735 294,000

5 220,000 0.621 136,620 0.681 149,820

6 220,000 0.564 124,080 0.630 138,600

7 220,000 0.513 112,860 0.583 128,260

8 100,000 0.467 46,700 0.540 54,000

9 100,000 0.424 42,400 0.500 50,000

10 100,000 0.386 38,600 0.463 46,300

Salvage Value( 10) 600,000 0.386 231,600 0.463 277,800TOTAL NVP 2,000,460 TOTAL NVP 2,169,580

Method 2: Risk Adjusted

Years

Annual expected

Earning after Taxes

PV Factor 20% PV PV Factor

8% PV

Underground Mining

1 360,000 0.833 299,880 0.926 333,360

2 360,000 0.694 249,840 0.857 308,520

3 360,000 0.579 208,440 0.794 285,840

4 360,000 0.482 173,520 0.735 264,600

5 230,000 0.402 92,460 0.681 156,630

6 230,000 0.335 77,050 0.630 144,900

7 230,000 0.279 64,170 0.583 134,090

8 130,000 0.233 30,290 0.540 70,200

9 130,000 0.194 25,220 0.500 65,000

10 130,000 0.162 21,060 0.463 60,190

Salvage Value( 10) 150,000 0.162 24,300 0.463 69,450TOTAL NVP 1,266,230 TOTAL NVP 1,892,780

By Risk Adjusted Method

THE DECISION

• According to the calculation result, all the results are negative regardless of the method and discount rate used (the investment cost > NVP)

• Therefore we decided NOT to take either alternative, as they both will result in a net loss

Investment Cost

Present Value By Certainty Equivalent

Method (6%)

Profit / (Deficit)

PV By Risk Adjusted Method

(10%&20%)

Profit / (Deficit)

PV By Risk Adjusted Method

(8%)

Profit / (Deficit)

Strip Mining 3,600,000 1,897,885.67 -1,702,114.33 2,000,460 -1,599,540 2,169,580 -1,430,420Underground Mining

2,000,000 1,561,208.52 -438,791.48 1,266,230 -733,770 1,892,780 -107,220

THE END

Thank You