Chapter 18 MINI CASE (p. 475): STRIK-IT-RICH GOLD MINING COMPANY
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will need to purchase land that its geologists believe is rich in gold. Strik-it-Rich’s management believes that the expansion will allow it to mine and sell an additional 2,000 troy ounces of gold per year.
The expansion, including the cost of the land, will cost $2,500,000. The current price of gold bullion is $1,400 per ounce and one-year gold futures are trading at $1,484 = $1,400(1.06).
Extraction costs are $1,050 per ounce. The firm’s cost of capital is 10%. At the current price of gold, the expansion appears profitable: NPV = ($1,400 – 1,050) x 2,000/.10 – $2,500,000 = $4,500,000.
Strik-it-Rich’s management is, however, concerned with the possibility that large sales of gold reserves by Russia and the United Kingdom will drive the price of gold down to $1,100 for the foreseeable future. On the other hand, management believes there is some possibility that the world will soon return to a gold reserve international monetary system. In the latter event, the price of gold would increase to at least $1,600 per ounce.
The course of the future price of gold bullion should become clear within a year. Strik-it-Rich can postpone the expansion for a year by buying a purchase option on the land for $250,000.
What should Strik-it-Rich’s management do?
Include in your discussion an analysis of how NPV would be affected if the price of gold were to rise or fall significantly.
Is buying a purchase option on the land a good idea? Why or why not?