SOA_FAP_Mod1Exercise01-01Assignment.pdf

Module 1 Exercise: Can-Do Mining

Introduction Module 1 introduced you to actuarial work and the Control Cycle framework used by actuaries to complete their work. The elements of the Control Cycle include reviewing the relevant External Forces while working through the Define the Problem, Design the Solution and Monitor the Results stages and while applying Professionalism to the work. In Module 1, you reviewed the history of the actuarial profession with special emphasis on how the Control Cycle has formed the foundation for actuarial work for some time.

What is actuarial work? How would the famous actuaries of the past answer this question? We think the evidence is that they would have replied: Actuaries apply actuarial skills to gather and analyze the best information they can possibly find about trends, risks, demographics and cultural practices while adhering to the Control Cycle when approaching a problem so that they can design solutions that minimize risk and monitor the results on behalf of their clients.

What are actuarial skills? Actuarial skills certainly include the application of the Control Cycle, the analysis of risk, the determination of mathematical equivalence, effective general business abilities and enabling skills such as being able to communicate the results of the work. You will be asked to use all of these skills in this Module 1 End-of-Module Exercise.

As you work through the tasks described below, ask yourself these questions:

Could this be a routine actuarial assignment in the future? Is the 15% contingency sufficient and reliable? What elements of the Control Cycle are covered in this exercise? What are the key or material elements of the problem? Who are the audiences for the written communication? Have I communicated clearly and in a way that my audiences would prefer?

Questions similar to these form the foundation of all actuarial work.

Your Role It is the end of 2005. You are an employee in the Finance Department of Can-Do Mining Limited (Can-Do), a Canadian-based subsidiary of USA Mines, Inc. Normally you spend your time on more conventional actuarial issues (e.g., employee and retirement benefits), but occasionally you are pulled into other matters. This is one of those times.

About Your Company Can-Do is considering the purchase of the South Face Mine, which is owned today by Mountain Mining Canada Limited (MMCL). MMCL is a Canadian-based subsidiary of Mountain Mining Corporation, a U.S.-based holding company with operations located throughout North America.

2003 - 2013 Society of Actuaries | SOA_FAP_Mod1Exercise01-01Assignment.docx| Page 1

The Business Problem South Face Mine is located adjacent to the North Fork Mine, a property owned by Can-Do. If Can-Do purchases South Face Mine, its strategic location would enable Can-Do to cut the costs of operating its North Fork Mine by up to $1.5 million annually for the next 20 years, the projected remaining lifetime of the North Fork Mine.

Moreover, MMCL has closed the South Face mine and is faced with decades of closure and reclamation costs, costs MMCL would clearly like to transfer to Can Do.

MMCL, however, is a savvy company. Although the South Face Mine is of little value to any other mining company, MMCL recognizes the strategic advantages of the South Face Mine to Can-Do. Therefore, you can expect MMCL to drive a hard bargain.

Your Assignment

As Can-Do begins to develop its negotiating strategy for the purchase of South Face Mine, the Vice President of Mergers and Acquisitions, B. Wilder has begun to try to determine the walk- away point.

A walk-away point is the amount at which a buyer (seller) in a negotiation would rather walk away from a deal than pay more (accept less).

In this situation, the walk-away point is the highest amount Can-Do would be willing to pay to acquire the South Face Mine. It can be calculated as the difference between the values of the cost savings Can-Do would expect to realize and the additional costs it would expect to incur as a result of the purchase of South Face Mine.

Wilder has asked you to help determine the walk away point, which is critical to Can-Dos negotiating strategy, and has since followed-up with a detailed memorandum describing exactly what he would like you to do. To complete the assignment, he has included an Excel spreadsheet containing several worksheets that have been prepared by other Can-Do personnel. He has asked you to include your calculations in this Excel file so that a complete package can be handed over to management. Read the memorandum and complete all the tasks Wilder describes. When complete, return to the Fundamentals of Actuarial Practice course and use the facility to upload your completed exercise files.

A Note About Formulae Used in This Exercise

During this exercise, you will note that several worksheets use interest discount functions. These concepts can be found in the Excel files that you used in the Credit Insurance case study in Section 5 of this module. As a reminder, you should be familiar with these formulae:

(1 + i)tThe accumulated value of $1 over a period of t years given an annual rate of interest of i, t 0.

vt = (1 + i)-tThe discounted value today of $1 payable t years from now given an annual rate of interest i, t 0.

v = 1/(1 + i) or (1 + i)-1


A Note About Sensitivity Tests You will note that Wilder asks you to complete sensitivity tests for a number of assumptions with respect to the closure and reclamation costs. Under a sensitivity test, you simply alter your model or an input to your model to determine how much the model output (i.e., the answer) will change under a given scenario. For example, the lump sum value of reclamation costs will be lower if the costs last 20 years rather than 25 years. The sensitivity test answers the question how much lower, both in absolute (e.g., $2 million) and in percentage terms (e.g., a 5% drop).

A Note About Reporting

When reporting the results of their work, professional actuaries are explicit about the data, methods and assumptions used. During this exercise, you will be required to do the same. You should follow the specific outline provided by B. Wilder in his memorandum.

Thanks Special thanks are offered to the anonymous donor of the data used in this exercise.


Memorandum To: FAP Module 1 Candidate

From: B. Wilder VP, Mergers and Acquisitions, Can-Do

Re: South Face Mine

Date: December 11, 2005

Thank you for agreeing to support our analysis of the potential purchase of the South Face Mine from Mountain Mining Canada Limited (MMCL).

Our engineers and financial analysts have been hard at work estimating the cost savings we could realize if we purchase the South Face Mine. Their analysis shows that, through a combination of improved surface logistics and optimal location of new drift mines (i.e., mines accessed horizontally from the side of the earth rather than from straight down), there could be savings over the next 20 years. These savings could be up to $1.5 million the first year and will increase with inflation in subsequent years. Our economists project that inflation during this period will run between 3% and 6% annually.

Offsetting these savings, however, are closure and reclamation costs that we would assume as part of the purchase. MMCL has provided us with its current work papers regarding these costs. They can be found in the Excel spreadsheet entitled SOA_FAP_Mod1Exercise01-02AssignmentSpreadsheet.xls. Notice that there are five separate worksheets in this file; you should familiarize yourself with each. Please note that Ive included a detailed description of each worksheet in the appendix.

Costs have been projected through 2026 by MMCL. As you examine MMCLs work papers, be aware that there are three different types of costs. Some are short term; most of these will be incurred within five years. Others are annually recurring costs that will be incurred during the entire reclamation period. Other costs will not be transferred to Can-Do (e.g., severance costs). They would remain with MMCL. In addition, MMCL has recognized the residual (salvage) value of the equipment, etc. that remains on site. If Can-Do purchases the South Face Mine, this salvage value will accrue to Can-Do. Most of the salvage value would be earned in 2006.

When reviewing MMCLs cost projections, please keep in mind that Can-Do may be able to bear some costs at little or no marginal cost. For example, Can-Do may have inspectors on staff who can conduct required inspections at no marginal cost to Can-Do. Finally note that MMCL has included a 15% contingency allowance in its calculations.

Like Can-Do, MMCL is a Canadian-based subsidiary of a U.S.-based holding company. As such, it has to report to the parent in accordance with the US Financial Accounting Standards (FAS). MMCLs projections are reported on both an FAS and on a management basis. The projections were produced for separate purposes at MMCL. We suspect the management projections are more complete but you should review all to ensure your analysis is complete.

Based upon this information, please prepare a written memorandum that answers or addresses the following questions or issues: 1. Inflation is not reflected in MMCLs projections. Based upon MMCLs projections and assuming a 6% interest rate for

discounting purposes, please determine the inflation rate that is equivalent to the 15% contingency allowance. When calculating this value, please ensure that you remove the costs that you would not expect to be transferred to Can-Do and reflect any cost benefit that Can-Do would realize from internalizing some of the costs (for example, inspections).

2. There are clearly risks that the durations of MMCLs short and long term cost projections will be exceeded. Please prepare three sensitivity tests of the duration of the costs in MMCLs projections by adding:

One year to the short term costs; Two years to the short term costs; and Five years to the long term costs.

3. Re-value MMCLs projections and the durational sensitivity tests using an inflation assumption of 3% and no contingency allowance. Also sensitivity test the inflation rate assuming the rate increases to 4%.

4. Sensitivity test the discount rate assumption of 6% by assuming it changes to both 5% and 7%. 5. The sensitivity tests will enable us to examine the risks associated with the duration of the post closure costs and with

inflation and investment income during the post closure period. Please identify any other risks we should be concerned about.


6. Based upon all of your work, at what amount do you recommend we set our walk-away point? 7. Based upon all of your work, what are the key risk factors (i.e., the most important assumptions) in your assessment? 8. Management will use your report. As a result, it should well-organized and understandable. Your report must summarize

the data, methods and assumptions that you use in your analysis. If you have any ideas for managing the risks identified, please include them in your report.

Your Deliverables You should prepare two deliverables: a written memorandum and an enhanced spreadsheet. These are described below.

The Memorandum After youve completed your analysis to arrive at your answers or to address the issues presented above, please write a memorandum reporting your results. Your memorandum, which you should create in Microsoft Word (or compatible word processing program), could be organized as follows: Executive SummaryThis section of the memorandum summarizes in a single page the issues that we should be most

concerned about and provides background to the reader in a few sentences. For actuarial reports, the summary often identifies the data, its source and how it was modeled. It should clearly state your major conclusions. Good executive summaries state recommended actions to address any outstanding issues and state any outstanding concerns in a compelling way.

IntroductionThis section of the memorandum expands upon the background offered in the executive summary. DataThis section of the memorandum summarizes data for the readers of actuarial reports. This section also provides

observations about the data that help the reader understand the data, its source and its strengths and weaknesses. Really good observations set the stage for the following sections. Detail such as data adjustments can be placed in an Appendix. Important information about the data such as a summary, commentary and weaknesses of the data should normally be part of the body of the report.

Analysis: Methods & AssumptionsThis section of the memorandum describes the methods and assumptions used to generate your results and to develop your observations, conclusions and recommendations.

Conclusions and RecommendationsThis section of the memorandum succinctly reiterates the findings of the memorandum.

The Enhanced Spreadsheet The Excel spreadsheet SOA_FAP_Mod1Exercise01-02AssignmentSpreadsheet.xls should be used to complete your analysis. (The appendix on the following page describes each worksheet in this spreadsheet.) As part of your assignment, you should modify this worksheet to complete your analysis and to generate tables to integrate into the Data and Analysis sections of your memorandum. Consider adding the following worksheets to this file before submitting: Data SummarySummarizes key data, extracted from the existing 2005-2006 Mgmt Budget Summary worksheet, to be

included in your memorandum. Modified BudgetModifies the existing 2006 Budget worksheet to eliminate and/or adjust MMCLs expenses to the

level that Can-Do would expect to incur. Modified Budget SummaryExtracts the Modified Budget worksheet to summarize modifications made to 2006 Budget. Modified Budget Valuation DetailSimilar to 2006 Budget Valuation Detail but should be tied to the Modified Budget

worksheet. Net Value of AcquisitionSimilar to Present Value of Addl Costs but should be tied to Modified Budget Valuation

Detail. In addition, the value of the cost savings should be incorporated. Value of ContingencyShows how the inflation rate that is equivalent to the 15% contingency allowance was determined. Sensitivity TestsSummarizes sensitivity tests, in which the amounts reported in the worksheet Net Value of Acquisition

are collected, to be included in the Analysis section of your memorandum.

Again, thank you for agreeing to support our analysis of the potential purchase of the South Face Mine. I look forward to receiving your results!


Appendix: MMCL Closure and Reclamation Costs Workpapers

The Excel spreadsheet, SOA_FAP_Mod1Exercise01-02AssignmentSpreadsheet.xls, consists of five worksheets, which are described below.

Worksheet 1: 2006 Budget Includes all of the data provided by MMCL. The column headings are defined below.

Column Column Heading Description

A Direct/Indirect Identifies whether an expense is direct or indirect B Major Category Identifies the Major Category to which each expense item is assigned C Minor Category Identifies the Minor Category to which each expense item is assigned D Description Describes each expense item E FAS? (Yes/No) Identifies expense items that must be reported to the US parent according to

the Financial Accounting Standard Board (FASB) F-Z 2006-2026 Estimated cash flow by expense item by year. Inflation is not reflected AA 2006 Budget Sum of columns F-Z

Worksheet 2: 2005-2006 Mgmt Budget Summary Summarizes the data in 2006 Budget in a pivot table. The Total 2006 Budget column shows estimates of the costs beginning 1/1/06 as estimated for the 2006 Budget. The column labeled 2005 Budget for 2006+ Costs shows comparable information as estimated one year prior. That is, the 2005 Budget for 2006+ Costs column shows estimates of the costs beginning 1/1/06 as estimated for the 2005 Budget.

Worksheet 3: 2005-2006 FAS Budget Summary Summarizes only the data in 2006 Budget that relates to information as it is required to be reported by the FASB for purposes of US Generally Accepted Accounting Principles (US GAAP). Again, the column labeled 2005 Budget for 2006+ Costs shows comparable information as estimated for the 2005 Budget.

Worksheet 4: 2006 Budget Valuation Detail Restructures the data shown in 2006 Budget in order to facilitate the valuation and sensitivity testing of the additional costs Can-Do will incur if it acquires South Face Mine. The column headings are defined below:

Column Column Heading Description

A Direct/Indirect Identifies whether an expense is direct or indirect B Major Category Identifies the Major Category to which each expense item is assigned C Minor Category Identifies the Minor Category to which each expense item is assigned D Description Describes each expense item E FAS? (Yes/No) Identifies expense items that must be reported to the US parent according to

the FASB F Short/Long/Salvage/

NA (Short/Long/NA/Salvage) Identifies whether an expense item will be incurred before the end of the projection period (Short), through the entire projection period (Long), does not apply to Can-Do (NA), or is a recoverable asset (Salvage). NA has been entered into the Severance item only. Based upon the guidance provided by B. Wilder, candidates should consider whether other expense items should also be identified as NA or if other expense amounts should be adjusted.

G Begin Year Identifies the year in which the expense begins H No. Years Identifies the number of years for which MMCL budgeted an expense item I Test No. Years Identifies the number of years during which an expense item is incurred in a specific

sensitivity test. The value of Test No. Years equals No. Years (column H) plus a value that is entered on the worksheet Present Value of Addl Costs.

J Annual Amount Amount of expense item during each year it is incurred


Column Column Heading Description K Value @ 1/1/Begin Present value as of Begin Year (column G) of an immediate annuity certain of Annual

Amount (column J) at the Effective Discount Rate. The Effective Discount Rate is the discount rate adjusted for inflation. (See worksheet Present Value of Addl Costs.)

L Value @ 1/1/06 Present Value as of 1/1/2006. The calculation assumes that all expenses are paid at mid-year.

Worksheet 5: Present Value of Addl Costs Calculates the present value of the additional costs that Can-Do will incur if it acquires the South Face Mine. Sensitivity tests may be performed by entering values into the cells highlighted in yellow. Each time any of the values in the yellow cells is changed, you must refresh the pivot table. To refresh a pivot table, right-click on any cell in the pivot table and left-click on Refresh Data.

Note that, when discounting at 0% interest with 0% inflation and a 15% contingency allowance, there are minor differences between the values shown on this worksheet and the values shown on 2005-2006 Mgmt Budget Summary and 2005 2006 FAS Budget Summary. These differences are due to rounding and may be ignored.

(Hint: To determine the inflation rate equivalent to the 15% contingency allowance, modify and/or eliminate cash flows according to Wilders guidance on 2006 Budget Valuation Detail, and note the total value with the 15% contingency allowance. Then eliminate the 15% contingency and solve for the inflation rate that reproduces the same value.)


IntroductionYour RoleAbout Your CompanyThe Business ProblemYour AssignmentA Note About Formulae Used in This ExerciseA Note About Sensitivity TestsA Note About ReportingThanksYour DeliverablesThe MemorandumThe Enhanced Spreadsheet

Appendix: MMCL Closure and Reclamation Costs WorkpapersWorksheet 1: 2006 BudgetWorksheet 2: 2005-2006 Mgmt Budget SummaryWorksheet 3: 2005-2006 FAS Budget SummaryWorksheet 4: 2006 Budget Valuation DetailWorksheet 5: Present Value of Addl Costs

SOA_FAP_Mod1Exercise01-01Assignment.pdf

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