The Benefits of Investment in the Medco Republic - Case Study Example

Investment in Medco Republic Introduction This report presents an analysis of the proposed capital investment of a large, U.K.-based company called Mineral PLC, in the Medco Republic, somewhere in Africa. Mineral PLC is an international mining company operating in several countries throughout the world, and whose activities include mining of gold, diamond, copper, and even crude oil exploration. The company’s strategic plans dictate that by 2008, expansion in Africa be explored for diversification of portfolio, where the objective is to further increase its profitability as a mining company. It has set its eyes on one African country called Medco Republic, a minerals-rich nation but at the same time a politically unstable country. Minerals PLC has to balance the opportunities and risks presented by such an investment prospect in Medco Republic. This report will attempt at evaluating the viability of a long-term investment in the Medco Republic as it plans to operate copper mining production despite the country’s volatile political atmosphere. Using investment parameters such as the Net Present Value (NPV) and the Internal Rate of Return (IRR), the report will analyze whether the investment is worth undertaking considering the risks. At the end of the report, a conclusion and corresponding recommendation will be made to guide Mineral PLC in its investment decision that it has to make soon. Aside from the analysis of the investment’s viability, this report will also discuss the concept of corporate social responsibility (CSR), and the pros and cons of such endeavor if undertaken by the company. Certain quarters are advocating CSR, while an opposing opinion suggests that it may be a useless idea given the prevailing factors in Medco Republic. And given the cross-country, trans-national nature of the investment, an attempt to analyze the foreign currency exchange risk associated with such an investment will also be undertaken. Hopefully, towards the end of the report, the financial director of the company will be enlightened and be able to discern the best option for the company to take, considering the bottom line requirements of shareholders: increase company profitability and increase returns to shareholders. While the data available from the case cover only the projected first five years of operations, the cash flow was projected to cover a ten-year operation in order to ascertain the viability of the project. Computing the NPV and the IRR on a five year projection, given the huge initial investments, may not be able to give a realistic result as accumulated cash flow will only become positive towards the end of the first five year period. Several assumptions were held in order to make possible the ten-year projection. Discussion Viability of the proposed investment Net present value, or simply NPV, is defined simply as the “difference between the present value of cash inflows and the present value of cash outlflows” (Investopedia). NPV has been described further as a parameter being “used in capital budgeting to analyze the profitability of an investment or project” (Investopedia). It relies heavily on the accuracy of the projected future cash flows, as results depend on what is inputted on the formula. An overstated, highly optimistic cash inflow and/or understated, pessimistic cash outflow projections will likely result in an inaccurate NPV. The internal rate of return, or IRR, on the other hand, is another popular measure used in capital budgeting. Investopedia defines it as “discount rate … that makes the net present value of all cash flows from a particular project equal to zero”. It usually refers to the rate of growth a project can generate. The higher the IRR, the more the project is likely to be accepted. IRR is usually compared to the prevailing rates of return in the securities market, wherein a higher project IRR is desired compared to the returns on an investment in the securities market. (Investopedia) In analyzing both the NPV and IRR of the proposed investment project in Medco Republic, the following data were used in the cash flow projection: Current market price for copper is 1500 per 1,000 kg with price increase at 5 per cent per year Production starts at 2010 with output of 10 million kg of cupper, assumed to be the same as sales volume. Successive years are pegged at 11 million, 12 million, 13 million, and abrupt decrease on the fifth year with 10.5 million only. The next five years were projected to have the same level of volume as on the fifth year, but with price of copper increasing as initially assumed. (See sales revenue table) Cost projections used data that were given for the first five years. For the next five years, the level of production was not increased but used only the data given for the fifth year, while the cost per unit was increased based on the initial projections. (See discounted cash flow and tax expense tables) Capital investment includes a pre-operating expense which covered the cost of the consultant, the cost of the equipment, and the site acquisition cost. (See total project cost table) The NPV and the IRR for the project were computed using Microsoft Excel spreadsheet. Given the above data and the various assumptions mentioned, it is more likely that the project will be accepted given the positive NPV (£9,253,034) and a higher IRR (21%) compared to the weighted average cost of capital (WACC) used, which is 15 percent. (See discounted cash flow table) The total project cost amounted to £55,000,000 spread over three years. Future net cash flows, when discounted and brought to the present, were compared to the total initial investment. The resulting difference pointed to a positive NPV and signifies the acceptability of the proposed investment in the Medco Republic. Foreign currency risk mitigation Investopedia defines currency risk as “a form of risk that arises from change in the price of one currency against another”. International operations of companies can always expect risks brought about by fluctuations in foreign currency exchange. As exchange rate moves erratically, financial managers will always have to look after their companies’ revenues and expenses quoted in foreign currencies. According to Brealey and Myers, there are two types of exchange rate risks. The first one is transactional risk, which arises when a company receives or pays a “known amount of foreign currency”. This type of risk is “easily identified and hedged”, which means this risk can be mitigated through some means within the investor’s control. The other type of risk is economic risk. (Brealey, et al) Minerals PLC should therefore be aware of such risks when investing in a mining operation in countries like the Medco Republic. Given the historical instability of the economy and politics in the country, fluctuation in foreign currency is almost a daily fact of life for foreign investors in Medco Republic. Several measures should be considered by Mineral PLC’s financial director to reduce the currency risk of the company. Among them are: 1. Hedging by buying currency forward contracts 2. Borrow dollars, convert them in the local currency, put the proceeds in the local bank, and withdraw it to pay for expenses at the end of the year. The difference between interest rates earned will be the same among the cost of buying local currency forwards, cost of borrowing dollars, buying on the spot market, and leaving the money on deposit (Brealey et al). By hedging, Minerals PLC will have to invest in a related instrument that might offset any adverse impact to be brought about by currency exchange fluctuation. By doing so, it reduces the risk that it has to take should an abnormal currency price fluctuation occurs. Hedging calls for some sort of a mini parallel investment in order to mitigate the impact of foreign exchange rate fluctuations. It is some sort of an insurance, where Minerals PLC must prepare for an adverse impact of an eventuality. Corporate social responsibility and sustainable development issues Browsing the internet reveals some interesting definition of corporate social responsibility (CSR) and how it is being applied by several businesses in the corporate world. The European Commission has defined it to be a “concept whereby companies decide voluntarily to contribute to a better society and a cleaner environment.” Further, it describes CSR “whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis”. It really is some sort of a mechanism where companies deliver back a portion of what they have taken away from the community where they operate, in a manner that would seek to uplift or improve the well-being of community members. On the other hand, there are some schools of thought that don’t subscribe to the idea of CSR. Such reasons would range from CSR being an “outright theft” whereby the money being spent on it really belongs to shareholders, and thus spending their money without their consent is construed as thievery, to arguments saying that these concerns about community welfare and the environment, for example, belongs to the turf of local politicians. Businesses, therefore, should only focus on the profit bottom line, and on how to increase the well-being of their shareholders only. (Baker) However, operating in a third world country with less sophisticated population, and where natural resources are exploited to the hilt by investors, with their unabated profits limited only by the taxes they pay to the government, it seems fair and proper to give back to the community a portion of what has been taken away from them. For one, the environmental impact of mining natural resources in a community would have far-reaching effects. Practicing CSR not only gives back to the community, it also promotes goodwill among the community where it operates. Internally, the company has a responsibility to ensure a production and operations process that are ethical, legal, and safe for its workers. In other words, Mineral PLC would do well if it were to take care not only of its workers’ welfare but also the well-being of the community or locality where it operates. Conclusion This report concludes that the proposed project of Mineral PLC in the African state of Medco Republic is a viable business undertaking given the positive NPV and the acceptable IRR derived from the project’s spreadsheets. The general criterion to pass the NPV test is to have a positive NPV while the criterion for IRR is that it should be higher than the rate of return on a similar investment in securities market to be acceptable. All tests point to the acceptability of the project as a financially viable project in the Medco Republic with a potential to improve the profitability of the company and increase shareholders’ wealth. While the promise of a good and steady of stream of cash flow to the company is there, the financial director should hedge against economic and transactional risks brought about by a fluctuating foreign currency exchange. The political situation in the target country of operations is just starting to stabilize and can still be considered as a risky country being a new “player” in the field. Economic and political uncertainties still hanging in the air must be dealt with properly with the appropriate caution and prudence when deciding on investment decisions vis-à-vis currency exchange risks. Mineral PLC will do well to invest on CSR and sustainability activities that aim to promote the welfare of its workers and the community where it operates. Gone are the days of steel hearts and cold business deals, as businesses tend to be more caring now not only to their stakeholders but also to the environment and communities where they operate. It thus promotes goodwill, peace and harmony in the community, and probably, there are non-monetary benefits and rewards that could be gained out of its investment on CSR activities. CSR activities are not only a tool for public relations, as it serves also some strategic objectives which the company can fully benefit from. References A beginner’s guide to hedging. Investopedia, a forbes digital company. As seen on the web. 07 December 2009 Baker, M. Arguments against corporate social responsibility. As seen on the web. 07 December 2009 Baker, M. Corporate social responsibility – what does it mean? As seen on the web. 07 December 2009 Brealey, R., Stewart Myers, and Alan Marcus. Fundamentals in corporate finance. 2007. Mc Graw Hill. New York, USA. What’s wrong with corporate social responsibility? Corporate watch. As seen on the web. 07 December 2009 Read More