Executive Summary
The strategically placed South Face Mine, owned by Mountain Mining Canada Ltd (MMCL) is the subject of the interest of Can-Do to present an offer to purchase the mine. If our company is successful in purchasing it the combination of improved surface logistics and the optimal placement of the new mine could result in the opportunity to save as much as $1.5 million over the course of 20 years. Yet, MMCL has closed the mine and has been investing in the closure and reclamation of the site; certainly, MMCL would prefer to transfer these costs to us.
The aim of this memorandum is to establish the walk-away point which is the maximum amount Can-Do will agree to provide in negotiations with MMCL by making use of the management budget supplied by MMCL and using the model of discounted cash flows, as well as tests of sensitivity on different assumptions.
Given the information contained included in the MMCL management budget, which includes the elimination of costs that cannot be transferable to Can-Do, or that can be internalized 1and taking that the interest rate is 6% for discounting and contingency allowance that is used in MMCL is a figure that implies that the rate for inflation is 2.55 percent.
In a study of different assumptions and assumptions, the sensitivity tests show that the short-term duration variance is the primary risk that is at play since a one-year extension of the short-term cost decreases the value of an acquisition by $6.6 million, from $15.5 million down to $8.9 million (58 percent of the original value). The extension for two years further decreases values by 6.4 million, to $2.5 million (16 percent of value). [2]
The suggested walk-away value is $14 million, which is less than the net value of acquisition calculated in the majority of tests of sensitivity, excluding those that deal with short-term duration and estimates of cost savings. This implies that thorough cost control must be implemented to prevent the expansion of short-term costs as well as a failure to achieve the estimated cost savings.
It is also important to remember that there are significant differences in cost items between budgets for 2005 and 2006. A thorough review of financial information is recommended to identify any potential risks or hidden issues.
Introduction
The purchase of South Face Mine, currently controlled by Mountain Mining Canada Limited (MMCL) could result in the possibility of reducing the operating expenses associated with the North Fork Mine, located near South Face Mine, by the estimated amount of $1.5 million annually over in the coming 20 years. because of the best place for new mines and better logistics.
But, it is anticipated that MMCL will require us to cover the closure and reclamation expenses. Thus, the value from the transaction is the sum of cost savings, minus the additional cost.
In analyzing the data and calculating the net value of the acquisition, we come up with the walk-away point that is vital and vital to our negotiation with MMCL. The other parts of this memo explain how to determine what is referred to as the walk-away point. Particularly, the goal for this research is:
Examine the financial information that is included
Conduct sensitivity tests to test hypotheses regarding the cost of reclamation and closure
Create a sensible walk-away point
Consider other risks that could be a risk for the selection for the walking-away location
Data
Data Source
MMCL has released the management budgets to cover the closure and reclamation costs at South Face Mine. The table below provides a summary of the projected costs for the period from 2006 to the present:
Item
Budget 06 ($’000)
Budget 05 ($’000)
Diff. ($’000)
Diff. (in %)
Direct Cost
6.0) 6. Treatment
3,391
1,583
1,807
114.15%
9.0) Tailing Storage Facility Reclamation
575
345
230
66.67%
11.0) Facilities Demolition
2,821
2,303
517
22.47%
12.0) Facilities/Equipment Disposition , and/or Salvage
218
347
(129)
-37.27%
13.0) The Disposition of Inventory
(5,270)
(5,511)
240
-4.36%
14.0) 1.4.0 Post Closure Monitoring Costs
1,319
320
999
312.03%
Total Direct Cost
3,052
(613)
3,664
-598.21%
Indirect Cost
15.0) Social-economic Costs
19,500
15,500
4,000
25.81%
16.0) Consultant Services
388
225
163
72.22%
18.0) Owners Management (post closing)
4,075
1,600
2,475
154.69%
22.0) Bonding Cost
270
90
180
200.00%
23.0) Contracts/Commitments/Royalties
1,250
705
545
77.30%
24.0) Taxes (Land, Buildings etcaEUR|)
2,700
4,800
(2,100)
-43.75%
30.0) Contingency*
1,760
1,021
739
72.40%
Total Indirect Cost
29,943
23,941
6,002
25.07%
Total Cost
32,994
23,329
9,666
41.43%
* Please note that the value of the above items doesn’t reflect any time value. Instead, an indirect expense “Contingency” implicitly bears the cost.
Table 1: Budget for Management for the Closure/Reclamation Costs from 2006 to the present
There are various kinds of costs, which include those that are short-term and will be incurred in five years, and long-term expenses that will be incurred throughout the entire period of reclamation. Additionally, there are salvage values of any equipment remaining at the site (i.e. Inventory Disposition) which are credited to Can-Do. Additionally, MMCL has included a 15% contingency allowance into its calculation.
In the above table, the table above clearly shows that there are significant discrepancies for many cost items that were included in the budgets in 2006 and 2005 and that is a sign of a lack of contingency allowance for 2005 to compensate for the negative growth of the cost estimates between 2005 and 2006. This raises concerns concerning the accuracy and credibility of the estimates. It is recommended that a comprehensive analysis of financial information and other data regarding the state of the mine uncover any possible issues that could expose our company to risk.
Adjustment of Data
The information provided will be subject to changes to determine the most reasonable walk-away points. These include:
Costs that are not moved to MMCL into Can-Do (e.g. segregation costs)
Eliminating costs that could be incurred by internalizing them into Can-Do (e.g. cost of inspection)
The specifics of adjustments to data are provided in the Appendix Table 2. illustrates the revised budget of South Face Mine starting in to the year 2006:
Item
Modified Budget 06 ($’000)
Direct Cost
6.0) 6. Treatment
3,391
9.0) Tailing Storage Facility Reclamation
508
11.0) Facilities Demolition
2,821
12.0) Disposition of Equipment/Facilities and/or Salvage
218
13.0) Disposition of Inventory
(5,270)
14.0) 14.0) Post Closure Monitoring Costs
1,319
Total Direct Cost
2,985
Indirect Cost
15.0) Social-Economic and Economic Costs
–
16.0) Consultant Services
388
18.0) Owners Management (post closing)
2,375
22.0) Bonding Cost
270
23.0) Contracts/Commitments/Royalties
–
24.0) Taxes (Land, Buildings etcaEUR|)
2,700
30.0) Contingency*
1,307
Total Indirect Cost
7,040
Total Cost
10,024
Table 2: Original and Modified Budgets from 2006 and to the present
Analysis: Methods and Assumptions
Contingency Allowance and Inflation Rate
MMCL has included the contingency allowance of 15% in its budget, but it has not taken into account the value of time for cost items. If the allowance is purely to cover the inflation rate, the implied inflation rate which is equal to the contingency allowance of 15% is determined to be 2.55 percent (using Excel’s Excel feature “goal find”) after the adjustment of data mentioned.
Testing for Sensitivity, Risks, and Walk-away Point
To understand the risks that underlie these assumptions, sensitivity tests have been conducted to determine the risks that are inherent in the assumptions used to create the cash flow forecasts (all with no reserve for contingencies). This table summarizes these results
Assumption
Annual Cost Saving
Value ($’000)
Scenario
Short-Term Duration
Long-Term Duration
Inflation Rate*
Discount Rate
Amount ($’000)
percent of Base
Cost Saving
Add’l Cost
NPV
Base
Base^
Base^
2.55%
6%
1,500
100%
21,934
7,102
14,832
1
Base + 1 year
Base
2.55%
6%
1,500
100%
21,934
13,614
8,320
2
Base + 2yr
Base
2.55%
6%
1,500
100%
21,934
19,914
2,020
3
Base
Base + 5 years
2.55%
6%
1,500
100%
21,934
7,512
14,422
4
Base
Base
3.00%
6%
1,500
100%
22,823
7,289
15,534
5
Base + 1 year
Base
3.00%
6%
1,500
100%
22,823
13,882
8,941
6
Base + 2 years
Base
3.00%
6%
1,500
100%
22,823
20,288
2,535
7
Base
Base + 5yr
3.00%
6%
1,500
100%
22,823
7,743
15,080
8
Base
Base
4.00%
6%
1,500
100%
24,947
7,724
17,223
9
Base
Base
3.00%
5%
1,500
100%
24,904
7,715
17,189
10
Base
Base
3.00%
7%
1,500
100%
20,994
6,902
14,091
11
Base
Base
3.00%
6%
1,350
90%
20,541
7,289
13,252
12
Base
Base
3.00%
6%
1,200
80%
18,258
7,289
10,970
The durations in Scenario Base represent the initial assumptions outlined in MMCL budget.
This inflation figure of 2.55 percent that is that is used in the scenario Base and #1-3 is derived from the calculation that was discussed in the previous section.
Table 3: Tests of Sensitivity
The table shows the net value of an acquisition under various combinations of short-term duration, longer-term length, the rate of inflation, and discount rates (Scenario Basis and #10-10). The table is evident that for the majority of scenarios the cost of acquisition is between $14-15 million. So, it’s prudent and prudent to choose the figure at $14 million as the minimum amount to walk away from.
Additionally, an additional test of sensitivity on estimates of savings in cost is conducted (Scenario 11-12). If compared with Scenario 4, it is evident that a decrease of 10% in cost savings results in a cost of acquisition to be below $14 million. This implies that a strict control is required to ensure whether the cost savings realized is in line with the anticipated one.
In the table The short-term duration is likely to be the most significant danger factor because any increase in this causes a dramatic reduction in value (by comparison of Scenario Base to Scenario #1-2 or Scenario #4 to Scenario #5-6). Can-Do must therefore pay close attention to the duration of cost projections for the short-term.
Conclusions and Recommendations
Based on using the revised cost budget and using a discount rate of 6 that a contingency of 15% allowance would result in the inflation rate being 2.55 percent. Additionally, following a review of different assumptions using a test of sensitivity the walk-away point of $14 million is enough to purchase South Face Mine. But, there are a few points that must be considered:
The wide variances in the budgets for 2006 and 2005 have raised questions about the accuracy and reliability of the estimated value included in the budget.
The implied rate of inflation of 2.55 percent is less than the lower limit of inflation rates predicted by economists.
The amount of the acquisition is highly dependent on the length of the short-term cost, based on the results of tests of sensitivity.
The calculation of the walk-away point is dependent on the assumption $1.5 million could be saved each year over 20 years. A slight reduction could be enough to result in an overall loss on the purchase if the price at which South Face Mine is purchased South Face Mine is close to the walk-away level.
For some costs including water treatment operation/maintenance costs and salaries of accountant/environmental person, they may be internalized to a certain extent; yet they are not removed for the determination of walk-away point due to their specialty. This is also a prudent walk-away point.
It is suggested that an in-depth investigation be conducted to confirm the cost estimates in the budget and to find any other potential issues. It is also suggested that a cost-control system is needed to ensure that the costs remain in line with the forecast in the event that Can-Do is successful in purchasing South Face Mine from MMCL.
Appendix to the Data Adjustment
Some reclamation and closure costs are taken out of The MMCL budgets of South Face Mine from 2006 to date since they are either eliminated (not transferable into Can-Do) or internalized. The table below provides a summary of the adjustments made to the data:
Direct/Indirect
Major Category
Description
Data Adjustment
Direct
9.0) Tailing Storage Facility Reclamation
Engineering and inspections
Internalized
Indirect
15.0) Social-Economic and Economic Costs
Severance
It is not transferrable to Can-Do
Indirect
18.0) Owners Management (post closing)
Tech Contract: $55k/yr for 20 years.
Internalized
Indirect
18.0) Owners Management (post-closing)
One manager for 4 yr at $150k /yr
Internalized
Indirect
23.0) Contracts/Commitments/Royalties
Employee Housing Buy-back
It is not transferrable to Can-Do
Please be aware that:
For some costs including water treatment operation/maintenance costs and salaries of accountant/environmental person, they can be internalized to a certain extent; yet they are not removed due to their specialty.
For salvage value, the salvage value will accrue until Can-Do in 2006 rather than 2026.