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Eastern Shallow LTD is a gold mining company operating a single mine .The present price of gold is $300 an ounce and it costs the company $250 an ounce to

produce the gold.Last year 50000 ounces were produced and engineers estimate that at this rate of production the mine will be exhausted in 7 years The

required rate of return on gold mines is 10%.

a- What is the value of the mine?

b- Suppose inflation is expected to increase the cost of producing gold by 10% a year but the price of gold

does not change because of large sales of stockpiled gold by foreign governments .Furthermore imagine that the inflation raises the required rate of return to

21%. Now what is the value of the mine

c- Suppose the company may shut reopen or abandon the mine in response to fluctuations in the price of gold

.Can the NPV method be used to value the mine under these conditions. For the below solution some things are not clear i will highligh

What is the value of the mine?

Answer: The present value of the mine is the present value of 7 years of

payments of $50/oz ? 50000 oz = $2.5M discounted at r = 10%. This present value is $12.171M.(what formula did u use

here)

b. Suppose inflation is expected to increase the cost of producing gold by 10 percent a year but the price of gold does not

change because of large sales of stock-piled gold by foreign governments. Furthermore imagine that the inflation raises the required rate of return to 21

percent. Now what is the value of the mine?

Answer: If the costs rise by 10% per year while the price remains the

same we will not operate the mine after one year. In the first year profits are (300 A 275) ? 50000 = $1.25M discounted one year at

r = 21%. In the second year profits are zero; we will not mine gold at $302.50 per ounce to sell at $300 per ounce. The value of the mine is $1.25M/1.21 =

$1.033M.(what does the A and question mark mean)

c. Suppose the company may shut reopen or abandon the mine in response to fluctuations in the price of gold. Can the NPV

method be used to value the mine under these conditions?

Answer: The NPV method can be used to determine the value of the mine if

the company can choose an optimal extraction policy. The analysis requires a potentially complex decision tree formulation and the determination of the

optimal strategy as a function of the path of the price for gold. The correct solution of the problem requires option%u2011pricing

methodologies.(what does %2011 mean)

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