Corporate Finance Concepts - Book Report/Review Example

FINANCE AND ACCOUNTING CASE STUDY ON ANALYSIS OF CORPORATE FINANCE CONCEPTS Executive Summary New Earth Mining (NEM) has identified an investment opportunity in producing iron ore which is the key input required for the production of steel. The company reported cash and marketable securities of $1,732m at the end of 2011. The company is planning to diversify its production into iron ore business. The company will have to expand their operations in the Kalahari manganese field, South Africa. The investment appears very attractive as evident from the demand of iron ore in market. The steel industry is the primary consumer of iron ore. NEM is considering the proposed investment and production to begin from 2015 onwards and expected cost of investment is estimated at $200m out of which 40 percent would be required in early 2013 and remaining 60 percent will be required in early 2014. The cost of investment includes construction, insurance, operating assets and working capital worth $20m. Fifty percent of $200m will be financed from overseas buyers. The present issue that the management is facing selection of discount rate for computation of NPV of the project. According to the VP of operations, the discount rate of NESA (new project) should be the cost of capital of parent entity or NEM. However, this approach is not suitable because NEM specialises in gold mining and new business is completely different (Armitage, 2005, pp.3-18). The account officer suggest that discount rate should be at least 24%, which is also recommended by external consultant. According to the financial analyst, the new project will be significantly leveraged by cheaper loans which will reduce the overall cost of capital of the project (Bose, 2006, p.57). The only risk faced by shareholders of NEM would be in form of dividends ($40m). The project cash flows should be discounted using Flow-to-Equity approach. This approach is highly recommended as this considers all the necessary factors. Table of Contents Executive Summary 1 Introduction 4 Financial Analysis 6 Conclusion and Recommendations 10 References 12 Bibliography 13 Appendix 14 Table 1: Sensitivity of NPV (in millions of dollars) to Ore Prices versus Various Discount Rates 14 Table 2: Projected Cash Flows for New Earth Equity Investment (in millions of dollars) 15 Table 3: Schedule of Debt Amortization Including Prepayments (in millions of dollars) 16 Introduction The prices of gold experienced an unprecedented boom at the beginning of 2013 when gold prices in market rose from $300 per ounce to $1,700 per ounce. New Earth Mining (NEM) is a Denver-based company that specialises production of precious metals. It is the largest precious-metal producer in United States. The company’s improved operating margins helped it to accumulate a large amount of cash as revealed in the balance sheet of the company. The company had $142 million cash and marketable securities in 2002 that accumulated to $1,732 million at the end of 2011. The company is planning to diversify its production into iron ore business. NEM has hired Drexel Corp as external consultants to conduct a feasibility and cost analysis. The company identified a new investment opportunity in South Africa where NEM was informed about the existence of a major iron ore body close to Kalahari manganese field in Northern Cape of South Africa. Soil tests reveal that approximately 30mt of iron ore with Fe content 60 percent could be produced from the field. Further, the effective life of mine is expected to be 15 years and the mine production would be optimal at 2mtpa. The investment appears very attractive as evident from the demand of iron ore in market. The steel industry is the primary consumer of iron ore. Also, seaborne trading require iron ore and the same has increased at 4.4 percent year-on-year. Most of the demand originates from Japan, China, India and Korea which dominates in steel production. Among them Korea and Japan have minimal domestic suppliers of steel and hence these economies have to rely heavily on seaborne market for getting steady supply of iron ore. The prices of iron ore are determined against an index representing most recent trades. There is optimism in the market that iron prices would be reasonable in future but recent trend in volatility of iron prices reveals the underlying risk of investment. Thus, a financial analysis of the investment is required that will help the investors to analyse whether making such an investment would be productive or not. Financial Analysis NEM is considering the proposed investment and production to begin from 2015 onwards and expected cost of investment is estimated at $200m out of which 40 percent would be required in early 2013 and remaining 60 percent will be required in early 2014. The cost of investment includes construction, insurance, operating assets and working capital worth $20m. Fifty percent of $200m will be financed from overseas buyers: i. $60 million will be raised from Chinese steel producers with senior debt at 9%. This will be repaid at $8m per annum from 2022 to 2028. ii. $40 million will be raised from EXIM and Japanese banks in form of senior debt at 7% which will be payable from 2016-2026. iii. $60m syndicate loan will be raised from US banks in form of senior loan at 10% repayable from 2016-2026. iv. $40m of loan would be required in 2013 and remaining $120m will be required in 2014. v. NEM will invest $40m in New Earth South Africa (NESA) using equity Now that the capital structure is discussed it is important to discuss the perspectives and opinions of different stakeholders: VP Operations The VP of operations recommended discounting projected cash flows generated by NESA at the weighted average cost of capital of New Earth, which is 14%. The cost of equity is 15%, cost of debt is 10% and leverage is assumed to be 12% of capital structure of the company. Consider the fact that New Earth will be the majority shareholder and parent entity, it is only justified that the project is evaluated using the WACC of the parent (Patterson, 1995, p.225). The Table 1 (see appendix) illustrates the sensitivity of the investment according the opinion of VP of operation. It shows that as the discount rates increases the profitability of iron ore production declines. Beyond 20% discount rate, the project becomes infeasible. Hence, according to the VP of operations, the discount rate should be as low as possible so as to maximise returns on investment. The drawback of this method is that the discount rate of project may not be equal to discount rate parent entity especially given the fact that business environment in US and South Africa are not same. Business in emerging economies is generally difficult and risky therefore requiring higher compensation. Higher risk means higher discount rates which has to be computed independently based on the factors influencing new investment and not NEM (Nikbakht, 2006, p.196). Accounting Officer According to the accounts officer, the proposed investment in South Africa carries substantially higher risk than previous investments. The argument is justified as NEM specialises in gold exploration and not iron ore hence it would be inappropriate to use company’s cost of capital as discount rate as suggested by the VP of operations. The method used by Accounts Officer is justified on the basis of the fact that discount should be revised according to similar investments made by peer companies in iron ore development in developing countries which will reveal the true profitability of investment. The new discount rate for the projected cash flows should be 24% (at least 10% above cost of capital of NEM). However, from Table 1 (see appendix) it is clear that the project will be unviable at such high rate of expected returns. Discount rate above 20% will actually result in net cash outflow if iron ore is priced at $80. In this case the company will have to price iron ore at $100 so that at 24% discount rate the investment remains feasible and that shareholders’ wealth is not eroded. External Consultant Due to differences in opinion regarding the selection of discount rate for estimating the NPV of the project, NEM hired eternal consultancy firm to provide an independent perspective on the profitability of new investment. They suggested that NESA investment in iron ore was stand-alone project for the company having opportunities for leverage. They agree that the cost of capital should be higher than 14% as new investment carried higher risk. They also argue that substantial leverage that the company plans to take for the new venture could result in lower overall cost of capital (or WACC) of parent entity due to inclusion of cheaper debt capital (SUBRAMANYAM, 1931, p.204). Hence, external consultants recommend that all cash flows of the project should be discounted at higher rate of cost of equity of 24% given substantial leverage and risks involved in the project. If the recommendations of the external consultants is followed then iron ore should be priced at $100 because at lower price of $80 the investment will result in net cash outflow and erosion of shareholders’ wealth. But it is also important to note that competition in market could force the company to price at lower range so as to attain price advantage. In that case, the company will be serious trouble and suffer from losses. Internal Analyst The financial analyst at NEM suggested that company should use ‘Flows to Equity’ approach to compare the discount rate or cost of equity for the shareholders of NESA. The analyst argued that the relevant investment of the company $40m in the form of dividends payable to the equity shareholders of NESA. Thus, given the fact that the investment will be significantly leveraged with senior loans, NEA will be completely insulated from danger of losing money more than the amount invested in form of equity in NESA. This method suggest full partitioning of cash flows to different classes of shareholders, namely debt and equity. The cash flows for equity and debt shareholders along with debt schedule and repayment is illustrated in detail in Table 2 & 3 (see appendix).The total cumulative EBIT for equity stakeholders at NESA will be $991.2m from an equity investment of $40m. Similarly, for a total debt amortisation of $160m, total contractual repayment obligation will be $27.2m and total repayment will be $132.8m. on the basis of these calculations the internal analysts suggested NESA’s discount rate/cost of equity to be 24% using Flow-to-Equity approach (Henschke, 2009, p.12). Conclusion and Recommendations New Earth Mining (NEM) has identified an investment opportunity in producing iron ore which is the key input required for the production of steel. The company reported cash and marketable securities of $1,732m at the end of 2011. The company will have to expand their operations in the Kalahari manganese field, South Africa. The present issue that the management is facing selection of discount rate for computation of NPV of the project. According to the VP of operations, the discount rate of NESA (new project) should be the cost of capital of parent entity or NEM. However, this approach is not suitable because NEM specialises in gold mining and new business is completely different. Also, the operating environment in developing country is not as conducive as that of developed county like US. There are certain import/export restrictions which elevate the risk of investment. Hence, the recommendations of the Account officer is quiet convincing who highlights this point to justify the point. The account officer suggest that discount rate should be at least 24%, which is also recommended by external consultant. Now, the internal financial analyst highlighted a differ perspective. According to the analyst, the new project will be significantly leveraged by senior loans (Donaldson, 2000, p.68). The cheaper debt capital will reduce the overall cost of capital of the project. As the only cash outflow by NEM would be in form of dividends ($40m), the project cash flows should be discounted using Flow-to-Equity approach that turns out to be 24% (Kruschwitz and Loeffler, 2006, p.67). This approach is highly recommended as this considers all the necessary factors. The company should use significant leverage as the loans would be easily available in 3 months given the strong financial position of the company. References Henschke, S., 2009. Towards a more accurate equity valuation: An empirical analysis. Germany: Springer. Kruschwitz, L. and Loeffler, A., 2006. Discounted Cash Flow: A Theory of the Valuation of Firms. United States: John Wiley & Sons. Donaldson, G., 2000. Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity. United States: Beard Books. Bose, C., 2006. Fundamentals of Financial Management. New Delhi: PHI Learning Pvt. Ltd. SUBRAMANYAM, 1931. Investment Banking. New Delhi: Tata McGraw-Hill Education. Armitage, S., 2005. The Cost of Capital: Intermediate Theory. United Kingdom: Cambridge University Press. Patterson, C., 1995. The Cost of Capital: Theory and Estimation. United Kingdom: Greenwood Publishing Group. Nikbakht, E., 2006. Finance. New York: Barron's Educational Series. Bibliography Müller, K. and Achleitner, S., 2008. Investing in Private Equity Partnerships: The Role of Monitoring and Reporting. Germany: Springer. Baker, Kent and Gary, Powell. Understanding Financial Management: A Practical Guide. United Kingdom: John Wiley & Sons. 2009. Print. Ehrhardt, Michael. Corporate Finance: A Focused Approach. United States: Cengage Learning. 2013. Print. Lumby, Stephen and Chris, Jones. Corporate Finance: Theory and Practice. United Kingdom: Cengage Learning EMEA. 2003. Print. Madura, Jeff. Financial Institutions and Markets. China: Cengage Learning EMEA. 2008. Print. Megginson, William and Scott, Smart. Introduction to Corporate Finance. United States: Cengage Learning. 2008. Print. Pratt, S. and Grabowski, R., 2014. Cost of Capital: Applications and Examples. United States: John Wiley & Sons. Appendix Table 1: Sensitivity of NPV (in millions of dollars) to Ore Prices versus Various Discount Rates Discount rates Iron ore at $80 Iron ore at $100 5% $337.11 $581.90 6% $295.08 $519.82 7% $257.62 $464.46 8% $224.18 $414.97 9% $194.23 $370.63 10% $167.37 $330.81 11% $143.22 $294.96 12% $121.46 $262.63 13% $101.81 $233.39 14% $84.03 $206.91 15% $67.91 $182.87 16% $53.27 $161.00 17% $39.96 $141.08 18% $27.82 $122.89 19% $16.73 $106.25 20% $6.59 $91.01 21% ($2.69) $77.02 22% ($11.21) $64.17 23% ($19.04) $52.33 24% ($26.24) $41.42 25% ($32.87) $31.35 26% ($38.99) $22.03 27% ($44.64) $13.41 28% ($49.87) $5.41 29% ($54.70) ($2.01) 30% ($59.19) ($8.91) Table 2: Projected Cash Flows for New Earth Equity Investment (in millions of dollars) Table 3: Schedule of Debt Amortization Including Prepayments (in millions of dollars) Read More