Kidman Resources is considering a binding agreement with Tesla inc. to supply 5000 tonnes of lithium hydroxide for three years.

Kidman Resources is considering a binding agreement with Tesla inc. to supply 5000 tonnes of lithium hydroxide for three years. However in order process the required amount of lithium hydroxide, Kidman Resources must consider whether to build a new refinery or outsource their supply ore (Li20).

Kidman Resources has undertaken a feasibility study costing $2 million to explore these two strategies.

Option 1: Building a new refinery

The construction and installation of a new refinery will cost $25 million. In addition, a processing plant will also need to be constructed at a cost $5 million. This plant will need to be supplied with grinding machines, DMS flotation machines and other equipment at a total cost of $15 million. Kidman Resources' current fleet of Haul trucks, water carts and dump trucks will meet the needs for this project, however until recently, the fleet has been earning a rental income of $100,000 per year.

Under the agreement with Tesla inc., the lithium mined is expected to generate a revenue of $16 million per year, which will increase by 2.5% per annum adjusted for rising costs. Due to the additional complexities involved with the construction and management of this new refinery, 5 new engineers (yearly salary per engineer $180,000) will replace 5 existing engineers (yearly salary per engineer $120,000). All other remaining labour force required is expected to cost $3 million per annum for the duration of the project.

For tax reasons you will expense the cost of the processing plant immediately. The cost for the construction and installation of the new refinery and associated machines and equipment will be depreciated over three years using the straight-line method. Due to the nature of the mining project, the machines and equipment will likely have a salvage value of $9 million at the end of three years. Finally, the required net working capital is $2 million.

Option 2: Outsourcing the supply of ore

Alternatively, Kidman Resources can contract BHP to supply the required ore to process into lithium hydroxide. Based on the required amount of lithium hydroxide, management has quoted a total cost of $30 million. BHP has however offered this rate on the condition that Kidman Resources pays 20% of the total cost in advance in the beginning of the year, with the remaining paid in equal instalments thereafter. Kidman Resources will process the ore into lithium hydroxide using existing facilities at an expected cost of $4.5 million per year.

Additional Information:

• The company's preference shares are currently trading at $0.70 each. The company's ordinary shares are currently trading at $1.17 each.
• The risk-free rate of return is 2.38 % p.a., and the return on the market is 7.80 % p.a.
• Debentures have a coupon interest rate of 9% p.a. and could be re-issued at the present time at an interest rate of 8.5% p.a. The debentures will be redeemed at their face value in three years' time.
• The mortgage loan is repayable in eight years' time and the current interest rate is 5.25% p.a. The mortgage was initially negotiated at 9.35% p.a.
• Term loans have a current interest rate of 6% p.a., but were negotiated at an interest rate of 7% p.a. They are repayable in full in three years' time. The term loans consists of regular semi-annually interest payments with the principal repaid at maturity
• Unsecured notes will mature in six months and will not be replaced. They have a current interest rate of 2.8% p.a.
• The current interest rate on the bank overdraft is 6.0% p.a.
• Interest on all debt securities is paid twice-yearly and the corporate tax-rate is 28
• percent

Evaluate the two options using NPV analysis and clearly identify which of the two alternatives results in a higher valuation for Kidman Resources. Include your opinion.