A mining company will spend $28 million in order to exploit a low-grade placer deposit of gold ore.They estimate the deposit will produce profits of $6 million per year for six years.They calculate the net present value (NPV)using an estimated cost of capital of 6%.What is the maximum that the cost of capital can deviate from this estimate that still makes the decision to mine worthwhile?
A)1.60%
B)1.66%
C)1.69%
D)1.72%
E)1.76%

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV), we need to discount the cash flows from the project back to their present value using the cost of capital of 6%. If the cost of capital were to increase, the present value of the cash flows would decrease, causing the NPV to decrease as well. Likewise, if the cost of capital were to decrease, the present value of the cash flows would increase, causing the NPV to increase.

To find the maximum deviation that still makes the decision to mine worthwhile, we need to find the point where the NPV equals zero. This is called the project's internal rate of return (IRR).

Using a financial calculator or spreadsheet program, we can find that the IRR for this project is approximately 16.9%. This means that the project will be worthwhile as long as the cost of capital is less than 16.9%.

To find the maximum deviation from the estimated cost of capital of 6%, we can subtract 6% from 16.9% and get a deviation of 10.9%. However, since the question is asking for the maximum deviation that still makes the decision to mine worthwhile, we need to take the minimum of the deviation from the estimated cost of capital and the estimated cost of capital itself.

Therefore, the maximum deviation from the estimated cost of capital of 6% that still makes the decision to mine worthwhile is 1.69% (which is the minimum of 6% and 10.9%). The correct answer is choice C) 1.69%.

A Mining Company Will Spend $28 Million in Order to Exploit