S. D. Bala suggests answers to the November 2004 CA (Final) paper on management accounting and financial analysis

S. D. Bala

YOU own an unused gold mine that will cost Rs 10,00,000 to reopen. If you open the mine, you expect to be able to extract 1,000 ounces of gold a year for each of three years. After that the deposit will be exhausted. The gold price is currently Rs 5,000 an ounce, and each year the price is equally likely to rise or fall by Rs 500 from its level at the start of the year. The extraction cost is Rs 4,600 an ounce and the discount rate is 10 per cent.

Required: i) Should you open the mine now or delay it by one year in the hope of a rise in the gold price?

ii) What difference would it make to your decision if you could without cost (but irreversibly) shut down the mine at any stage? Show the value of abandonment option.

Working Note 1: The following assumptions have been made: i) the initial cost of investment at Rs 10,00,000 or extraction cost per ounce at Rs 4,600 is not expected to change; ii) there are no additional expenses; iii) the entire quantum of extracted gold will be sold, and there will be no stock in hand, at the end of first, second or third periods; iv) there is no gestation period; production and sale commence immediately and are accrued at the end of the year; v) the question states that the price will change at the beginning of a year. Hence, the price prevailing today will be the price at the end of the first year, and so on.

Working Note 2: For the first full year cash inflow per ounce will be Rs 400, being the difference between selling price of Rs 5,000 less extraction cost of Rs 4,600.

For the 2nd year, the cash flow per ounce will be the same at Rs 400, as shown in Table 1.

For the third year, too, the cash inflow position will be the same at Rs 400, as in Table 2 (cash flow per ounce).

The workings can also be presented in a summarised form as in Table 3.

Flowing from this, it is clear that, given a 50/50 rise or fall of Rs 500 per annum, and on account of neutralising effect, the expected cash flow will continue to be Rs 400 per ounce per annum, if the current price of gold is Rs 5,000

Working Note 3: The net present value (NPV) computations are shown in Table 4. Two conclusions can be reached. First: NPV is negative at Rs 5,600 and the mine should not be opened now.

Also, we cannot open the mine when the selling price of gold is ruling below Rs 5,000 per ounce.

Evaluation, Part (a): Consider Working Notes 1 to 3.

Scenario one: Since the NPV is negative at Rs 5,600 (Table 4), the mine should not be opened immediately.

Scenario two: i) Opening of mine is delayed by one year; and ii) the price is Rs 5,500. Since the expected price is Rs 5,500, taking into account 50/50 rise or fall of Rs 500, the price for all future periods will only be Rs 5,500 (comparable to computations in Tables 2 and 3).

This is so because, if the gold price rises at year 1 to Rs 5,500 the rise and fall of Rs 500, on 50/50 basis thereafter will throw up only a uniform price of Rs 5,500. Profit per ounce, per annum will then be Rs 900 (Rs 5,500 less Rs 4,600). NPV computations are shown in Table 5.

This throws up a positive amount of Rs 11,24,909. The expected value of this strategy is Rs 5,62,454 (Table 6). The mine can be opened, if (and only if) the price at the beginning of second period stands at Rs 5,500.

Scenario three: i) Opening of mine is delayed by one year; and ii) the price is Rs 4,500. Considering that the project yields a negative NPV at an initial price of Rs 5,000, there is bound to be negative NPV at any price less than Rs 5,000. Therefore, if after a wait of one year, the price rules at Rs 4,500, the mine should not be opened.

Here it is assumed that the mine's life is three years from date of opening.

Part (b), strategy 1: See Tables 7, 8 and 9. At this point, we have to decide whether the mine should be closed at t-1 or not. It is clear that when the price is Rs 4,500 at t-1, the mine should not be closed, but should be closed if the price is Rs 4,000 at t-2.

When the price is ruling at Rs 4,000, the expected loss will be Rs 6,00,000 in that year. The probability of this loss is 0.25. Therefore, the value of option to close will emerge as shown in Table 10.

Evaluation of strategy 1: When mine is opened when price is Rs 5,000 (t-0).

i) Without an option to abandon, it has a negative NPV of Rs 5,600 (Table 4); and

ii) Value of option to abandon is the saving of loss amounting to Rs 1,12,685. Therefore, NPV with an option to abandon at t-2 is Rs 1,07,085 (being the difference between Rs 1,12,685 and Rs 5,600)

Strategy 2: i) Let us assume that the mine is opened, after a one-year wait, with a starting price of Rs 5,500.

ii) For this alternative, the mine has to be abandoned at t-3, if the price reaches Rs 4,500.

iii) The rationale is that there is likely to be a loss of Rs 1,00,000, and the probability of this occurring is 0.125. The expected value is presented in Table 11.

Evaluation of Strategy 2: i) Without an option to abandon, the expected value for this alternative is Rs 5,62,454 (Table 6)

ii) The NPV with an option to abandon is Rs 5,62,454 + 8,536, that is, Rs 5,70,990

Conclusion: i) value of option to abandon the mine under strategy 1 is Rs 1,07,085;

ii) Value of option to abandon the mind under strategy 2 is Rs 5,70,990; and

iii) Strategy 2 is optimal, and provides a better value, that is, wait for one year, open the mine if the price is Rs 5,500.

Exposure netting

THE process of managing foreign exchange risks, in which debit balances are netted off against credit balances such that actual currency flows take place for the net amounts is known as exposure netting. The objective is to save on transaction costs, by netting off inter-company (bilateral) or intra-group company balances (multilateral), before payment is arranged.

In bilateral netting, two entities are involved. The lower balances are netted off against higher balances, and the remainder is paid or received.

Example: Ambika P. Ltd is exporting pepper and other spices to a New Jersey customer. The rupee value of exports is Rs 84,32,000. The New Jersey importer also supplies canned-cherries to Ambika, invoiced in US dollars 125,000. The two inter-company balances could be set off against each other.

The net balance is computed at a rate on an agreed upon predetermined date, and the net difference can be received or paid.

In the instant case, the value of receipts from overseas customer is larger than the value of payments due. Assuming that the agreed INR/$ is Rs 45, the overseas customer can convert a sum of $62,377.78 at his end, and can remit an equivalent of Rs 28,07,000 (see Table 13).

Multilateral netting is adopted among three or more subsidiaries (or outfits) in the same group (under one control).

The procedure is a little more complex than bilateral netting, and is not applied to small-value transactions. The arrangement is generally coordinated by the group's treasury operations department, at its group headquarters. There are certain key areas: A common currency is to be decided upon; a method of establishing the exchange rates to be used for netting purposes is also to be decided upon; and local laws and regulations that govern each of the subsidiaries need to be considered (in some countries bilateral netting is feasible, in some others multilateral netting is prohibited).

The main advantages are: Transaction costs are reduced (purchase or sale of foreign currency, transmission costs, and so on); and float funds are reduced, leading to saving in interest costs.

Bilateral and multilateral netting techniques are in vogue internationally. These techniques have gained popularity both in the US and in the UK, for the reason that both the dollar and the pound are the two currencies where trading volumes in the exchange markets are rather high.

Insofar as India is concerned, the Reserve Bank of India's regulations do permit certain companies to hold a portion of receipts in foreign currencies under the Exchange Earners' Foreign Currency (EEFC) Account Scheme, to be used for payments to cover imports. This mechanism helps avoid double-conversion costs.

Exposure netting also signifies the extent to which an entity may need to effectively hedge its foreign currency exposures, which are reflected in both the asset and the liability sides of its balance sheet.

Assume that a trading house has both imports and exports. It can hedge its foreign currency risks fully, say, by taking forward cover separately for liability under imports, as well as for its export receivables. Rather than taking a forward position for purchase as also for sale of foreign currency, an entity may choose to take protection through forward-cover operations only to the extent warranted by the excess of either side over the other.

(This article was published in the Business Line print edition dated January 10, 2005)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.