24 Jul IS BUYING A PURCHASE OPTION ON THE LAND A GOOD IDEA?
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will ne Show more 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-Richs management believes that the expansion will allow it to mine and sell an additional 2000 troy ounces of gold per year. The expansion including the cost of the land will cost $2500000. The current price of gold bullion is $1400 per ounce and one-year gold futures are trading at $1484 = $1400(1.06). Extraction costs are $1050 per ounce. The firms cost of capital is 10%. At the current price of gold the expansion appears profitable: NPV = ($1400 1050) x 2000/.10 $2500000 = $4500000. Strik-it-Richs 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 $1100 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 $1600 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 $250000. What should Strike it rich management do? How would NPV 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? Show less
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