MAFASN2004.docPAPER – 2 : MANAGEMENT ACCOUNTING AND FINANCIAL
ANALYSIS
Question No.
1
is compulsory.
Answer any
four
questions from the rest.
Figures in the margin
indicate marks allotted to each question.
Working notes should form part of the answer.
Question 1
You own an unused Gold mine that will cost Rs. 10,00,000 to reopen.
If you open the
mine, you expect to be able to extract 1,000 ounces of Gold a year for each of three years.
After that the deposit will be exhausted. The Gold price is currently Rs. 5,000 an ounce, and
each year the price is equally likely to rise or fall by Rs. 500 from its level at the start of year.
The extraction cost is Rs.4,600 an ounce and the discount rate is 10 per cent.
Required:
(a)
Should you open the mine now or delay one year in the hope of a rise in the Gold price?
(b)
What difference would it make to your decision if you could costlessly (but irreversibly)
shut down the mine at any stage?
Show the value of abandonment option.
(20 marks)
Answer
(a)
(i)
Assume we open the mine now at t = 0.
Taking into account the distribution of
possible future price of gold over the next three years, we have
1.10
4,600

4,500]
0.5
5,500
[0.5
1,000
10,00,000
Rs.

NPV
×
+
×
×
+
=
(
)
2
2
(1.10)
4,600]

4,000)
5,000
5,000
(6,000
0.5
[
1,000
+
+
+
×
+
(
)
3
3
(1.10)
4,600]

3,500)
4,500
5,500
4,500
4,500
5,500
5,500
(6,500
0.5
[
1,000
+
+
+
+
+
+
+
×
+
=

Rs. 5,260
Because the NPV is negative, we should not open the mine at t = 0.
It does not
make sense to open the mine at any price less than or equal to Rs. 5,000 per
ounce.
(ii)
Assume that we delay one year until t = 1, and open the mine if the price is Rs.
5,500.
At that point :
(
)
12,38,167
Rs.
(1.10)
4,600)

(5,500
1,000
10,00,000
Rs.

NPV
t
3
1
t
=
×
+
=
∑
=
If the price at t
1
reaches Rs. 5,500, then expected price for all future periods is Rs.
5,500.
FINAL EXAMINATION : NOVEMBER, 2004
28
NPV at t
0
= Rs. 12,38,167/1.10 = Rs. 11,25,606
If the price rises to Rs. 5,500 at t = 1, we should open the mine at that time.
The expected NPV of this strategy is:
(0.50
×
Rs. 11,25,606) + (0.50
×
0) = Rs. 5,62,803
As already stated mine should not be opened if the price is less than or equal to Rs.
5,000 per ounce.
If the price at t
1
reaches Rs. 4,500, then expected price for all future periods is Rs.
4,500.
In that situation we should not open the mine.
(b)
Suppose we open the mine at t = 0, when the price is Rs. 5,000.
At t = 2, there is a 0.25
probability that the price will be Rs. 4,000.
Then since the price at t = 3 cannot rise
above the extraction cost, the mine should be closed.
If we open the mine at t = 0, when
the price was Rs.5,000 with the closing option the NPV will be:
(
)
(1.10)
1,000
4,600

5,000
10,00,000
Rs.

NPV
t
2
1
t
×
+
=
∑
=
3
(1.10)
1,000]
100)

100

900
00
9
900
[1,900
.125
×
+
+
+
×
+
=
Rs. 1,07,438
Therefore, the NPV with the abandonment option is Rs. 1,07,438.
The value of the abandonment option is:
0.25
×
1,000
×
(600) / (1.10)
3
= Rs. 1,12,697
The NPV of strategy (2), that to open the mine at t = 1, when price rises to Rs. 5,500 per
ounce, even without abandonment option, is higher than option 1.
Therefore, the
strategy (2) is preferable.
Under strategy 2, the mine should be closed if the price reaches Rs. 4,500 at t = 3,
because the expected profit is (Rs. 4,500 – 4,600)
×
1,000 = –
Rs. 1,00,000.
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