Reference no: EM132819694

STRIK-IT-RICH GOLD MINING COMPANY

• 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-Rich's management believes that the expansion will allow it to mine and sell an additional 2,000 troy ounces of gold per year.
• The expansion, including the cost of the land, will cost $2,500,000. The current price of gold bullion is $1,400 per ounce and one-year gold futures are trading at $1,484 = $1,400(1.06).
• Extraction costs are $1,050 per ounce. The firm's cost of capital is 10%. At the current price of gold, the expansion appears profitable: NPV = ($1,400 - 1,050) x 2,000/.10 - $2,500,000 = $4,500,000.
• Strik-it-Rich's 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 $1,100 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 $1,600 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 $250,000.

Problem 1: What should Strik-it-Rich's management do?

Problem 2: Include in your discussion an analysis of how NPV would be affected if the price of gold were to rise or fall significantly.

Problem 3: Is buying a purchase option on the land a good idea? Why or why not?