New Earth's Primary Line of Business - Term Paper Example

Running Head: Advanced Corporate Finance [Name] [Professor Name] [Course] [Date] [WORDS 1793] Executive Summary New Earth's primary line of business has been gold exploration and production. The company looks to diversify its investments in the exploration and production of iron ore in South Africa. This report concludes that New Earth should not invest in the South African iron ore mine, since its financials are very speculative. Based on the analysis of the company’s long-term debt and the cash-equivalent, several factors are discovered. First, the debt exceeds the cash. In this case, New Earth would be on the verge of financial depression, and investing any further would increase its debt. Four valuation approaches are applied on the investment, namely VP-Operations, Accounting Officer, External Consultant and Internal Analyst, are applied. Of the fours, Internal Analyst’s approach is the most applicable. The approach is based on the premise that the price of stock is equal to the total current and future cash flows. Its key advantage is that it attempts to put the valuation of the shares and dividends, on the basis of the sum to be paid to the investors. In principle, this approach offer a very solid ground for determining the cash flow through dividends. As a result, since dividend is what New Earth would use to pay the investors, it would offer a clear-cut way of returning money to the investors without increasing its long-term debts. Table of Contents Executive Summary 1 Table of Contents 2 Introduction 3 Four valuation approaches identified in the case study 4 VP Operations 4 Accounting Officer 5 External Consultant 5 Internal Analyst 6 Alternative to Net Present Value (NPV) 7 Investment Opportunity Analysis 7 Conclusion 8 References 9 Introduction New Earth's primary line of business has been gold exploration and production. The company looks to diversify its investments in the exploration and production of iron ore in South Africa. This is since the sustainability of gold prices at their current levels. The company’s primary business line has been gold. In the case, iron ore has a potential market. For instance, since iron ore represents some 95 percent of the metal used across the globe, this is an indicator of a vibrant and ready market. Further, while the price of gold has been speculative, the price of iron was not expected to fall unexpectedly given the strong global demand. Based on these facts, iron ore presented an investment opportunity for New Earth. In all, $200m is needed to complete the project. $100m has to be sourced from overseas buyers. The debt-holders include two Chinese steel producers ($60 million), EXIM and Japanese bank syndicate ($40 million) and US banks 9$60m syndicated loan). Further, there is need to value the investments. Four valuation approaches are applied on the investment opportunity, namely VP-Operations, Accounting Officer, External Consultant and Internal Analyst. Four valuation approaches identified in the case study VP Operations The VP operations places emphasis on discounting the project cash flows that would be generated at NESA by New Earth's 24 percent weighted average cost of capital. The major strength is that the approach has the potential to provide an accurate picture of New Earth’s true value once the current and future cash flows were estimated. Using the approach, it is possible to determine how much cash New Earth would have after it had invested $40 million into NESA using equity (McCallum, 2003). The approach however has a number of shortcomings. For instance, it is purely hypothetical since it could only be assumed that profits would continue to grow at a similar rate in the future. Indeed, this could not be ascertained since New Earth anticipated such risks as associated with making huge investments in South Africa such as political upheaval and corruption. In the case, industry experts had ranked the country among the top countries where political upheavals affected mining (Anon, 2004). Accounting Officer The accounting officer proposed to discount the projected cash flows at 24 percent. This was a 20 percent premium above New Earth's cost of capital. The major advantage of this approach is that it recognised the capital reinvestment. Using this approach, the accounting officer based the value of New Earth on projected future results instead of on assets. It was indeed useful for New Earth since the company expected future results to be different based on the company’s investment in iron ore in South Africa. In the case, iron ore has a potential market. For instance, since iron ore represents some 95 percent of the metal used across the globe, this is an indicator of a vibrant and ready market. The approach however has several disadvantages. For instance, it may understate the value of balance sheets (Anon, n.d.). Additionally, it had the potential to give the new business in South Africa a lower valuation, since the accounting officer had already built the perception that the new business line was riskier than the old (Steiger, 2008). External Consultant The External consultant suggested that New Earth's South African investment in its subsidiary would be higher than New Earth's own 14 percent cost of capital since the new investment carried considerable risks. The approach considered cash flows as the primary measure of NESA’s suitability. According to the approach, the value of New Earth’s new investment is taken to be equivalent to the capital invested into NEWS at a reasonable rate of return that is required to generate the income that is equal to New Earth’s average income reflected in the balance sheets for the recent years. The key advantages of this approach include that fact that it does not rely on projected or foresights but the average of results that New Earth showed in the recent past (Baum et al, 2001). It is also useful for New Earth, since the company has predictable cash flow earning. Analysis of the company’s financial statements for the past 10 years (2002 to 2012) shows progression in earning. Its major disadvantage however is that by relying on the company’s past earnings, it ignores the company’s future performance, even as the company plans to venture in a risky business line (Suozzom et al, 2001). Internal Analyst New Earth's internal analyst proposed that the company should compare the company’s flows for equity holders at NESA's cost of equity to the Equity to the equity invested by New Earth. The approach was based on the premise that the price of stock was equal to the total current and future cash flows. Its key advantage is that it attempted to put the valuation on the shares and dividends, basing on the sum to be paid to the investors. In principle, this approach offer a very solid ground for determining the cash flow through dividends (Abdina et al, 2008). In this case, since dividend is what New Earth would use to pay the investors, it would offer clear-cut way of returning money to the investors without increasing its long-term debts. In any case, even though the company would not be able to pay the dividends because of the high investments costs in the South African mine, the price of its stock can still be calculated under the assumption that once the South African investment has picked, it would begin to pay the dividends. However, using this approach, New Earth’s ability to sustain a certain rate of dividend growth in the long-term is difficult to project (Kaplan Financial, 2013). In any case, of the fours approaches, it is the best approach since it relies heavily on validity rather than speculations. Using the approach, the company would be completely cushioned from the risks of losing more money that what has been invested in NESA. Using this approach, in trying to negotiate a better deal with the customers and lender, the focus should be on the dividends allowed (Vecchio, 2000). Alternative to Net Present Value (NPV) Real Options Analysis can be used in the place of net present value to valuate New Earth. The underlying principle in the alternative approach is the way in which it points out to a real option as an investor’s right -- and not an obligation -- that has to be taken on an asset at a cost or a predetermined date. For instance, in the case scenario, real option refers to the option to delay the investment on NESA. For instance, the project may have a negative net present that is based on the company’s present cash flows. However, the project may still be valuable based on the characteristics of the option. Therefore, while the negative net present value may make Net Earth to reject investing on the South African mine, it should not make it to conclude that the right to the project is worthless (Damodaran, 2006). Investment Opportunity Analysis On review of the company’s long-term debt and the cash-equivalent, the key objective is to determine whether the debt exceeds the cash. In this case, New Earth would be on the verge of financial depression. It would therefore be unwise to invest at this juncture. In the case, analysis of the company’s balance sheet at the end of 2011 shows that the company has a debt of $2,272,000 and cash-equivalent of $1,732,000. This shows that the new investment opportunity is at a significantly higher risk than the company's usual line of business in gold. Further, New Earth has a balance sheet with a cash-equivalent of $1,732,000, long-term debt of $2,272,000 and a gross margin of 54%, such a balance sheet does not give New Earth an advantage to invest in the South African iron ore mine since more debt service will not offer the company cushion when iron ore market suffers. This means that New Earth’s financial perspective is very speculative. Conclusion This report concludes that New Earth should not invest in the South African iron ore mine, since its financials are very speculative. In the next two years, since the guaranteed returns are high while the risk are also high, the company should instead focus on reducing its debts instead of relying on investing large amounts of money upfront. This will enable the company to invest in the South African iron ore mine at a time where it can cushion itself when the market suffers. [WORDS 1793] References Abdina, Z., Comlin, J., Nadeau, J. & Smetana, N. (2008). Net Present Value vs. Real Options Analysis. Retrieved: Anon (2004). Advantages and Disadvantages of Valuation Methods. Retrieved: Anon (n.d.) What is Valuation?. Retrieved from: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/background/valintro.htm Baum, A., Crosby, N., Gallimore, P., McAllister, P. & Gray, A. (2001). The Influence Of Valuers And Valuations On The Workings Of The Commercial Property Investment Market. Retrieved: Damodaran, A. (2006). Valuation Approaches and Metrics: A Survey of the Theory and Evidence. Retrieved: Kaplan Financial (2013). Discounted Cash Flow Technique. Retrieved from Kaplan Financial website http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Discount%20cash%20flow%20techniques.aspx McCallum, T. (2003). Valuation of a business, Part 3. Professional Development Network. Retrieved: Steiger, F. (2008). The Validity of Company Valuation Using Discounted Cash Flow Methods. Retrieved: http://arxiv.org/ftp/arxiv/papers/1003/1003.4881.pdf Suozzom P., Cooper, S., Sutherland, G. & Deng, Z. (2001). "Valuation Multiples: A Primer." Global Equity Research. Retrieved from: http://www.macabacus.com/docs/valuation-multiples-primer.pdf Vecchio, J. (2000). Dividend Discount Model. Retrieved: Read More