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FINS5511 Corporate Finance

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Question

HBP Mining Ltd (HBP) currently operates an iron ore mine and has commissioned GB to determine whether to continue operating the mine or to abandon it. The price of iron ore is currently $55 per ton, with the mine producing 80,000 tons of iron ore per year and costing $5 million per year to operate. In its current state, the mine has enough iron ore to continue operating for 90 years. Shutting the mine down would require HBP to bringing the land up to environmental standards, which is expected to cost $5 million. Reopening the mine once it is shut down would be an impossibility given current environmental standards. 

HBP's risk management department believes that (given current economic conditions) the price of iron ore has a 45% probability of going up by 25%, and 55% probability of going down by 15% every year for the next three years. After three years, economic conditions will have stabilised so that the price of iron ore will remain constant for the remaining life of the mine. They have also estimated HBP's cost of capital to be 12%. 

Requirements:

1. Draw a decision tree to summarise the dilemma faced by HBP.   
2. Calculate the NPV of continuing to operate the mine by working your way backwards through the tree and taking into account the option to abandon.    
3. Based on your answer in (2), what should HBP do with the iron ore mine?   

We ask that you keep all your formulas as simple as possible - don't go overboard and make them unnecessarily complicated. It makes your assignment difficult to understand which can lead to us not allocating you part marks for your effort, particularly if your answer is incorrect! The decision tree can be done in Excel or attached to the report.
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