Evaluation of a New Mining Project and the Efficient Market Hypothesis

Introduction to Guangming Plc and the New Mining Project

Guangming Plc is an emerging plant nutrient provider with phosphate mining projects based in the UK. The company aims to be a standard for green mining of fertiliser feed minerals and a world class plant nutrient producer and supplier across the UK. Corporate Social Responsibility (CSR) is at the core of this project. Guangming is particularly interested in changing the name of mining to exemplify responsible mining and processing.

Recently Guangming has secured a right to undertake a mining project given the company’s increased popularity in the UK. It has secured an expanse of almost 10,000 hectares of agricultural land in a remote part of the country. This land holds a phosphate deposit, the largest sedimentary phosphate deposit in the UK. You are a financial analyst in the company. The new mining project has the following estimates. The project life is seven years. The initial capital investment for the new project needs £1.85 million. It is expected that the scrap value of the investment at the end of project life would be 11.50% of the original investment cost. This new project would bring annual sales revenue of £6.25 million in the first year. After the first year, the annual sales is expected to grow at a real rate of 7.5% per year. The annual inflation rate is expected to be 2.20% each year. It is expected that the gross profit margin is 10% every year. The new project will have other indirect annual operating expenses, which is estimated to be 3.5% of its annual sales. It is estimated that a further £0.85 million per year of Guangming’s existing indirect overhead costs are to be apportioned to the new product project. As part of the evaluation of the projects, the company had paid a consulting firm £0.95 million to perform a test marketing analysis. The expenditure was made last year but is yet to be paid. Corporation tax would be payable at 25% in the year in which it arises.  

To fund the projects, the company has decided to make a rights issue of ordinary shares. The company has a reliable history of dividend payments and is expected to pay dividends annually for the foreseeable future. The annual dividend paid by the company on its ordinary shares has grown from £0.21 per share ten years ago to the present level of £0.38 per share and is expected to continue to grow at a similar rate in the future. The company’s ordinary shares are currently trading at a price of £4.5 ex-dividend. 

At the company’s board meeting, the Guangming’s CEO asked you to evaluate the new project to examine whether it can add value to the whole company. The CEO asked you to use the subjective approach and applies an adjustment factor of + 0.95 per cent points to the cost of capital for such risky new projects. The CEO was concerned whether the new project would be more vulnerable to the fluctuations in the initial investment cost and the sales revenue. So the CEO has asked you to address this concern by conducting appropriate analysis. The depreciation method applied for the project is decided to be straight line depreciation approach. 

Required:

1.Evaluate the new project with the NPV and IRR approaches. You need to explain your reasons for including or excluding any of the information provided in this case study. After the evaluation of the project, you need to recommend an appropriate course of action for the company. You also need to comment on what other aspects could be considered in the project evaluation.

2.Explain how you could address the CEO’s concern on the impact of the estimated initial investment cost and the sales revenue on the new project. Demonstrate how you would calculate your answer. 

“Investors cannot beat the market as stock prices reflect all information”. Considering the efficient market hypothesis and its forms, discuss the above statement. Make references to academic literature where relevant.