Custom Sovereign Mines Investment Essay

Sovereign Mines is a big mining company that is engaged in mining activities. The company is in the process of purchasing a drilling machine. This paper intends to analyze the investment that the company intends to make, and advise the board of directors of the company on the best project to invest. This is done by taking into account the costs and benefits of the project in question.

Machine A

Costs - $100,000

Installation cost - $5,000

Salvage value - $5,000

Initial capital - $80,000

Annual revenue - $150000p.a

Operating expenses - $102,000

Cost of the machine:

Initial cost of machine ($100,000) + installation cost ($5000) + depreciation N1 ($11,667) + working capital ($80,000) – salvage N2 ($1500) = $174,333

Cost of capital = $174,333

Cash flows table 1-for Machine A.

N/B: all figures presented in this table are in $

Items/years	Cash flows	Operating expenses	Gross profit before tax and depreciation	depreciation	Profit before tax	Taxation 30%	Add back depreciation	Operating income
1	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100
2	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100
3	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100
4	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100
5	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100
6	150,000	(102000)	48,000	(11667)	36,333	(10,900)	11,667	37100

Table 2 shows calculations of the net present value of Machine A;

N/B: figures in this table are in $.

Years	Operating income	P.v/f(10%)	Present value
1	37,100	0.9091	33,728
2	37,100	0.8264	30,859.4
3	37,100	0.7513	27,873
4	37,100	0.6830	25,339
5	37,100	0.6209	23,035
5	37,100	0.5645	20,943

Total present value = $133,704.35          N1- depreciation = (105,000-5,000/6) = (16,667) 0.7 = 11,667

Less p.v.f = $174,333               N2-Salvage = (5000-0) 30% = 1,500

Net present value = $- 40,628.65

MACHINE B

Purchase cost - $150,000

Installation costs - $4,000

Initial working capital - $70,000

Annual revenues - $155,000

Cash expenses  - $95,000

Salvage value - $2,000

Corporate tax - 30%

Service life - 10years

Initial cost of the machine;

Purchase (150,000) + installation (4,000) – depreciation N3 (10640) + working capital (70000) - salvage (600) = 212,760

Initial cost of the machine = 212,760+2,500= 215,260

Table 3 - cash flow table

N/B: the figures represented in this table are in $

year	1	2	3	4	5	6	7	8	9	10
Cash flows	155,000	155,000	155,000	155,000	15,5000	15,5000	15,5000	15,5000	1,55000	1,55000
Cash expense	(95,000)	(95,000)	(95,000)	(95,000)	(9,5000)	(9,5000)	(9,5000)	(9,5000)	(9,5000)	(9,5000)
Gross profit	6,0000	6,0000	60,000	60,000	60,000	60,000	60,000	60,000	60,000	60,000
Less depreciation	(15,200)	(15,200)	(15,200)	(1,5200)	(1,5200)	(1,5200)	(1,5200)	(1,5200)	(1,5200)	(1,5200)
PBTAD	44,800	44,800	44,800	44,800	44,800	44,800	44,800	44,800	44,800	44800
Tax 30%	(13440)	(13,440)	(13,440)	(13,440)	(13,440)	(13,440)	(13,440)	(13,440)	(13,440)	(13,440)
Add depreciation	15,200	15,200	15,200	15,200	15,200	15,200	15,200	15,200	15,200	15,200
Operating income	46,560	46,560	46,560	46,560	46,560	46,560	46,560	46,560	46,560	46,560

Table 4- shows calculations of the net present value of Machine B:

N/B: figures in this table are in $.

Year	Operating income	PVFA(16.8%)	PV
1	46,560	0.8562	39,865
2	46,560	0.7330	34,129
3	46,560	0.6276	29,221
4	46,560	0.5373	25,017
5	46,560	0.4600	21,418
6	46,560	0.3939	18,340
7	46,560	0.3372	15,700
8	46,560	0.2887	13,442
9	46,560	0.2472	11,510
10	46,560	0.2116	9,852

PVOF B = 218,494

Less PV = (215260)

Net present value = 3,234

Co-variance = 0.6

Standard deviation (AS) 200 = 25%

Standard deviation of Sovereign mines = 35%

(0.6/0.25*.35).7% + 12% + 16.8%

The board of directors should purchase machine B because it has a positive net present value. The method that has been used to arrive at this decision is by calculating the net present value of machines A and B, whereby the one with the highest positive value is preferred over the other. In our case, machine A has a negative net present value, which means that it will not yield any profit in its service life of 6 years. On the other hand, Machine B will yield some positive returns within its service life of 10 years. Therefore, it would be wise for the board to purchase machine B instead of machine A.

The cash flows used have been arrived at by deducting the total revenue earned from the usage of the machine by operating expenses and by deducting taxation. This gives operating income that will be discounted as per the company’s discount rate in order to get the net present value.

What happens if tax rate changes from 30% to 40%:

A tax rate change will have an impact on the overall operating income realized from the operations of the mines.

For example, in the case of machine A:

N/B: The figures presented in this table are in $

years	1	2	3	4	5	6
PBT	36,333	36,333	36,333	36,333	36,333	36,333
Tax (40%)	(14,533)	(14,533)	(14,533)	(14,533)	(14,533)	(14,533)
Add depreciation	11,667	11,667	11,667	11667	11667	11,667
Operating income	33,467	33,467	33,467	33,467	33,467	33,467

Profit before tax is estimated at $36,333, while per annum increase in tax rate will reduce the operating profit from the initial $37,100 at the rate of 30% to $33,467 at the rate of 40%.

The above scenario whereby the government funded maternity leave programs will probably lead to an increase in tax from the current 30% to 40%. This will result in reduced operating income and decreased NPV for both machines.

Updating Discount Rate / Risk-Free Rate / Expected Equity Risk Premium by Using a Proxy Company

There is a need for Sovereign Mines company to continue updating its discounting rate. This will help reduce the losses that the company may incur as a result of using the out-of-date discount rate. This section of the paper provides a report on how the board can update the current out-of-date discount rate by using a proxy company. The purpose of this section is to come up with an accurate beta that the company can use to discount its returns on investment. The beta represents a risk-free premium rate. An accurate beta will help the company use an accurate set of discount rate, thus reducing risks of overvaluing or undervaluing the firm.

To choose a proxy company, a survey was carried out to collect information about different companies listed on the New York Stock Exchange. Observation was the main method of data collection in this case, whereby a various firms’ financial performance, as well as value assets and liabilities, were taken into account. After careful consideration, ten companies involved in mining activities as well as production of various products were chosen. Secondary sources of data were also used to identify the ten companies. A careful study of the financial statements of these firms was done in order to select a proxy company. After careful consideration, Coca-Cola Company Limited was chosen to act as a proxy company. To select a risk-free rate the company used in discounting its cash flows, interview was employed as a method of data collection. Interviews with the chief financial officer of the company provided some valuable information about the company’s risk free rate and expected equity risk premium. The decision to use Coca-Cola as a proxy company was based on the fact that the company resembles Sovereign Mines in many ways. The main factor that was taken into consideration was the company’s cash flows and other financial statements that resembled those of Sovereign Mines in many ways.

It is important to understand what a discount rate entails. It is a percentage through which discounted cash flows estimations are reduced in all the time period outside the present period. Estimation of the most appropriate discount rate may prove to be difficult and tend to be one of the uncertain aspects of discounted cash flows. Smaller changes that occur in interest rates magnify the problem by causing big changes in the world of business. In most financial evaluations the discount rate that is used is usually taken as the value of the rate of capital.

The company uses the following beta:

(Covariance / standard deviation of A * standard deviation of B)

The company also employs the following formula to calculate the required rate of return:

RRR = (risk-free rate * Beta) + (equity risk premium)

It was easy to calculate the new discount rate that Sovereign Mines can use to analyse a number of its investments. For the purpose of accuracy, the data over a 5-year period was used to calculate the proxy company’s beta. A deep analysis of the company’s financial statements for the last five years was also carried out. The purpose of using this historic data was to enhance accuracy, which is vital in calculating the beta of any given company.

The procedure used to estimate the risk-free rate and equity premium ensured that the breakdown of expenditure base asset pricing systems is in line with the stochastic features of the risk-free rate and equity premium, which most scholars refer to as durability or transaction cost. Though the above frictions may cause higher occurrence of information elements, expenditure-based pricing systems are expected to be successful in the long-run. There are two expenditure-based systems that are used in this case, such as time-separable value and  constantinides system. In this case, an estimation of ARCH system vector was used, which included the equity return and pricing kernel, as well as the fixed model, that were used to examine the implications of the model for the risk-free rate and equity premium of Coca-Cola Company. It is important to note that none of these models perform well in the case of quarterly horizon, but in the long run the constantinides system tends to be in line with the variance and means of the equity premium observed. It allows to capture time changes in equity premium, thus it can be in line with the recorded risk-free rate. A conclusion was arrived at that the risk-free rate and equity premium puzzles are basically challenges for short-term returns. In order to overcome these challenges, it was necessary to observe the returns of Coca-Cola Limited for a minimum period of 5 years.

When studying the company’s financial statements, we noted that a risk-free rate of 8% was used, while equity premium/expected rate of return stood at 14%. In order to calculate the best discount rate using the information gathered from the proxy company it is also important to remember that the company’s standard deviation for machine A is 0.25%, while that of machine B is 0.35%.

The up-to-date beta for Sovereign Mines was arrived at through the following formula:

(0.6/0.25*0.35)*8 +14 = 14.54

Where 14.58 is the obtained discount rate that the firm should use in its investment analysis because it is up–to-date.

This part deals with the doubts that I, as a chief investing officer, may have about choosing the right proxy company. To overcome this fear, as well as those of the board, this part of the report contains a sensitivity analysis to see how changes in the beta affect investment choice. The report will also include implications of the sensitivity analysis to the board.

Sensitivity analysis can be defined as a study of uncertainties in the pricing model. It can be subdivided into diverse origins of those uncertainties in the pricing model. Sensitivity analysis is absolutely crucial for supporting the process of decision-making in an organization, especially decisions relating to investment projects. It also enhances communication between the concerned parties in an organization and increases understanding of the quantifying model that is used by a given organization. Finally, it aids in development of the firm’s pricing model by helping identify errors within the existing model.

It is safe to say that an asset can have a zero beta when returns change independently from the changes in market returns. On the other hand, a positive value of the beta usually implies that returns on an asset depend on market returns, whereby the two are above their normal average values or in other cases they are below their average values. Finally, a negative value of the beta implies that returns on an asset tend to move in opposite direction from market returns. This means that one of the two will be above the average value and the other will be below the average value.

Changes of the beta in our case imply that it may either increase or decrease the value of the discounted cash flow, depending on the new value of the beta. Changes in the beta value may have an impact on the choice of a machine to be purchased. It also influences the value of net present value, whereby it may increase or reduce the overall value. Therefore, it is necessary to make the right choice with regards to a proxy company.