CAPITAL MARKETS, AC6103 Lectures 3 & 4 Mini Assignments – Groups Groups 1, 2, 3, 4, 5,6,7,8 Case Study: Molycorp: Financing Financing the Production of Rare Earth Minerals Minerals (MCP) The case requires two substantive valuations exercises: valuing Molycorp’s common equity and valuing the the convertible debt financing option. Note that these two analyses are not independent of each other; the valuation val uation of the convertible debt financing has has to use Molycorp’s share price as a key input.
Group 1 Would you buy Molycorp’s shares at USD 11.49 per share in August 2012? Present the arguments for and against buying at this price.
Reasons for buying MCP shares: 1. REEs (rare earth elements) are unique, un ique, scarce and important (p1 in case). cas e). The demand for rare earth elements has risen substantially in the last 60 years because of their unique electrical, mechanical and magnetic properties. REE’s are critical inputs to many m any technologies ranging from defence defence applications to clean energy to your smartphone. smar tphone. The average smartphone may contain up to 62 different types of metals. And the REEs play a vital role. A single iPhone contains contains 8 different rare earth metals; across a range of different smartphones smar tphones you will find 16 of the 17 rare r are earths metals in the periodic table. REEs tend to be scattered scattered within the earth. Typically they are not found in high concentrations concentrations in one place. Extracting them can be expensive and tricky. And they are a finite resource; there is currently no known substitute for many of these elements. el ements. 2. Good long term demand – demand – CAGR CAGR = 7% (p2 in the case). 3. Molycorp has scale and scope advantages:
Verticle integration is valuable – valuable – mine mine to magnets Production cost is 50-70% below the competitors (p3)
4. Analysts see upside over next 12 months, $36 floor (p1) 5. REE prices are still above historic levels (Ex 1) 6. Investors have over reacted to the bad news: Time to buy is when others are scared Analyst says it “not a bad as it looks” (p1) Market-Book Ratio = 0.86 (below 1.0). AKA price-to-book ratio. This measures the market value of the company relative to its book / accounting value. Calculation = the company's market cap divided
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by the company's total book value from its balance sheet. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Reasons NOT to buy 1. 2. 3. 4. 5. 6. 7. 8.
Stock price has fallen from $77 to $11 (p1) REO prices are way down (X-1) Very capital intensive; need more $$ (p1) Project Phoenix (Mountain Pass) not done New entrants (X-10); new supply coming – more competition Substitutes and recycling (p2) Cash flow from Operations is falling (X-3) Insiders are cashing out in 2 nd offerings (p4):
Sold 25m shares in 2011 (p4)
Had 82.3m shares out at year end 2010 (X-4)
Sold 30% of total shares at c.$50 per share
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Group 2
What are the key elements of Molycorp’s business plan? Identify and assess the key risks facing Molycorp as it implements its plan.
Key elements of the business plan: The company owns the only rare earth mine in the western hemisphere with significant deposits etc.
Goal was to implement a vertically integrated mines to magnets strategy – would allow for low cost production, processing, and distribution of REOs. This strategy had two key parts: A) the modernisation and expansion of the Mountain Pass facility, known as Project Phoenix; B) the acquisition of downstream refining and manufacturing capabilities. Both required significant capital investment.
Description of Major Risks Political Risk:
Chinese production and quotas on REEs (p2)
Completion Risk:
Can MCP complete Project Phoenix – cost and schedule overruns, cost increase; but Analyst says the project “remains on budget and on time” (p6)
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Revenue Risk:
A combination of REE price, project completion, and throughput risks (X-1): Price of REEs is volatile and falling (X-1) New supply is coming; up to 135k tons (p2) Only 4% of the reserves are proven (40k / 1004k tons, P2)
Reserve/Resource Risk: Financial Risk:
MCP has high leverage – above its target leverage ratio (p5, X-10, Table C): $263.2m of current debt; coming due in 2012 (p5 and X-4) Market value leverage ratio is 47% in Aug ’12; far above target. MCP needs funds for debt service and capex – can it raise new capital?
Funding Risk:
Asset Risk:
MCP has $1 bn of intangible assets and goodwill (32% of total, X-4). How is this valued?
ASK THE CLASS: what is the most significant risk facing Molycorp? Funding risk. MCP needs more capital to finish project Phoenix and may not be in a good position to raise more capital. It needs funds for debt service and capital expenditure (capex). The fact that REO prices have fallen substantially (see Ex 1) has left MCP unable to generate much operating cash flow to fund the project internally. As a result, it will need to raise external finance exactly at the time its prospects are not very appealing to some/many investors. _____________________________________________________________________________
Group 3 We now need to focus on this need to raise capital. How much and what kind? To do this we need to start by assessing where Molycorp is in terms of its capital structure. 1. Describe Molycorp’s capital structure. 2. What is a reasonable (i.e. market value) leverage ratio for Molycorp? Explain your reasoning. 3. In your opinion is Molycorp currently at its optimal leverage ratio?
Q1 Exhibit 10 says MCP two year average market value leverage ratio (Debt / Value) was 7.6% compared to a target market value leverage ratio of 20-30% (p5). Q2
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Using data from Exhibit 4, you can calculate the current leverage ratios which are far in excess of target (20-30%, p5) at least after the recent stock price decline, and far in excess of the most comparable peer firm (Lynas Corp): 46.% vs 19.5%. How do we get these numbers? See spreadsheet, MCP Leverage Ratios As at 30 June 2012, Lynas was at the lower end of its target range and Molycorp was at the upper end of the target range.
Q3 Optimal leverage ratio?
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Group 4 1. To become operational and implement its business plan, how much external capital must Molycorp raise between July & December 2012? 2. What is its financing need in 2013? 3. Analyse the firm’s sources and uses of cash. 4. What funding alternatives are available to Molycorp? 5. Should Molycorp issue debt, equity or a combination of both? Explain your reasoning and discuss the relative merits of each funding alternative. 6. How should MCP approach making this decision?
Q1 To answer this we need to analyse the current sources and uses of cash. See spreadsheet L3 Cash Sources & Uses Aug – Dec 2012. MCP needs USD 500m.
Q2 USD 137.2 (see TN 2b sources and uses of cash in 2013). Q3 This will have been answered to a degree in Qs 1 & 2. If Project Phoenix gets completed and comes on line, the expected cash flows are substantial and the cash needs relative low .. at least according to the forecasts in Exhibit 9 (which contain some assumptions). MCP needs to raise $500m to funds its obligations for the second half of 2012. The need for extra funds stems mainly from the following: capex required to complete Project Phoenix USD 289m; repayment of debt ($263m = $230m convertible debt +
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$33.2 million of other debt, page 5; investment in net working capital ($202 m) associated with the Mountain Pass mine becoming operational; and interest expense ($36.24 .. see TN Table E page 8).
Q4 Page 5. Straight debt (bonds) up to $350m. Convertible debt of up to $350m. Common shares from $100m to $350m.
Qs 5 & 6 Given the need for $500m, the company will have to use both equity and debt.
How should MCP decide re the kind of capital to raise? The simple answer is that MCP should choose the alternative(s) with the lowest cost, where the cost include the direct cost as well as the impacts of costs such as financial distress, signalling and under pricing. Start by looking at the capital structure relative to the target capital structure. We have already been given this data. I refer to the current market value leverage ratio which is 46.5% and the target is 20-30% (page 5). The company’s leverage ratio is well above its closest comparable, Lynas Corp (19.5%). THEREFORE MCP seems to be overleveraged in both absolute and relative terms.
If MCP raised $500m of additional straight debt, it would increase its leverage ratio to 56% (TN Ex 3). BUT if MCP issues $500m of equity, its leverage ratio would fall to 38% (assuming no change in the share price); this is still way above its target range. This suggests that MCP should consider issuing equity to sort out its funding crisis, and at the same time improve its leverage ratio. However, we must consider that the share price is likely to fall in response to the decision to issue equity (a signalling effect) and thus diminish the reduction in the leverage. We also need to consider that MCP’s share price has fallen from $77 in May 2011 to $11.49 in Aug 2012. Given this, it is possible that the current market price may not reflect the firm’s fundamental value. If the market is currently undervaluing MCP, perhaps because investors have overreacted to the bad news, issuing equity could be very expensive. _______________________________________________________________________________
Group 5
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1. To what extent does Molycorp need tax shields? Discuss the “static trade off theory” of capital structure. 2. Molycorp’s share price has fallen from a high of USD 77 in May 2011 to USD 11.49 in August 2012. Is the market under or over valuing the company? 3. Explain why the market is under valuing Molycorp. 4. Explain why the market is over valuing Molycorp.
Q1 See TN exhibit re capital structure & debt to equity trade off. The curve shown provides a chance to review the “static tradeoff theory” of capital structure (debt has the advantage of generating incremental interest tax shields and the disadvantage of generating incremental distress costs). To what extent does MCP need tax shields today versus in the future? How costly is financial distress, especially for an unproven and incomplete facility? Are there other factors – such as flexibility or control over free cash flow – that better explain MCP’s current and its target capital structure? EG to what extent are investment decisions affected by the presence of long term debt in the capital structure? AGENCY COST ISSUES. Shareholders may not invest if they think that profits will be used to pay off existing debt holders. It is highly likely that financial flexibility and credit ratings are the most important debt policy factors. The degree of stock undervaluation is important to equity issuance.
See the JR Graham, CR Harvey article in the Journal of Financial Economics 60 (2001) 187-243., “The Theory and practice of corporate finance: evidence from the field”.
Q2 It is possible that $11.49 does not reflect the company’s fundamental value. If the market is undervaluing MCP, it may be because investors have over reacted to the bad news. This means that issuing equity could be extremely expensive. It is also possible that MCP is undervalued following the release of the poor second quarter results for 2012 and the need for additional financing – there is plenty of “behavioural evidence” that shows individuals are prone to overweighting recent information. If the market is overvaluing MCP, this would be a point in favour of issuing new equity.
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You have to conduct a valuation analysis of MCP’s common equity in order to be able to move forward to closer deciding the right capital structure for the company – more debt, more equity, more of both – but in what weights? _______________________________________________________________________________
Group 6 1. Calculate Molycorp’s cost of capital. 2. Estimate the Asset Betas for Molycorp and Lynas and work out the average asset beta. Use a debt beta of 0.30. All other inputs are in the case. 3. Estimate the Expected Returns and WACC for Molycorp based on its long run target leverage ratio of 25%, the simple average of the target range (p5). Use a market risk premium of 6% and assume a marginal corporate tax rate of 35%. All other inputs are either in the case or are derived from data generated either in the Step 1 calculation or in this calculation (e.g. Beta; e.g. Expected Return). SEE SPREADSHEET.
4. Prepare a Sensitivity Analysis of Molycorp’s WACC to variation in its estimated asset beta and target leverage ratio using the following : Target Leverage (D/V) inputs: 10%; 20%; 25%; 30%; 40% Asset Beta inputs: 1.70; 2.00; 2.07; 2.20; 2.50
What do the results of this sensitivity analysis tell you? Ans: a systematically risk company.
The Asset Betas are the unleveraged equity betas for the two companies. The asset beta is a proxy for the business risk of the project.
Business risk represents the uncertainty in the projection of the company’s cash flows which leads to uncertainty in its operating profit and then uncertainty in its capital investment requirements. The Equity Betas reflect both the business risk of a company’s operations (asset beta) AND the financial risk (leverage) of the company.
Financial risk represents the additional risk placed on the common shareholders as a result of the company’s decision to use debt i.e. financial leverage. This is because with the addition of more debt to the structure the residual claim of the shareholders becomes less certain and hence more risky.
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If a company’s capital structure is 100% equity then beta would only reflect business risk. This is because there is no debt in the capital structure. And in such a company analysts may refer to the beta as asset beta.
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Group 7 Valuation of Molycorp using DCF analysis. 1. Review Molycorp’s financial projections and calculate the free cash flows and terminal value. Most of the data inputs are in the case. 2. Discuss whether you believe that the projections are reasonable. What, if any, changes would you make and why? How could the various business risks, discussed at the beginning of this case, impact the analysis? 3. Calculate Molycorp’s total enterprise value. 4. Calculate Molycorp’s common equity value per share. 5. Prepare a sensitivity analysis of Molycorp’s Common Equity Value using the following data: WACC inputs: 13.3&; 14.2%; 14.7%; 15.2%; 15.8% Terminal Value Growth Rate: 0.0%; 1.4%; 2.2%; 3.0%; 4.0%
What do the results of this sensitivity analysis tell you? SEE THE SPREADSHEETS FOR G7 ________________________________________________________________________________
Group 8 Valuation of Molycorp’s Convertible Notes
The valuation of the convertible debt financing alternative is a two-step process: A. Valuation of the bond component B. Valuation of the option component The valuation of the convertible debt alternative is achieved by adding the values of the bond and option components together.
1. Identify the nine assumptions and inputs to calculate the value of the convertible bond. Assume a Discount Rate for Bond Cash Flows of 11.3%. All other assumptions and inputs can be found in the case on p5 & one on p 7. 2. Over a 10 year time period, inclusive, and using data from No.1, work out the following for each year: Bond Cash Flows
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Discount Factor Present Value 3. Compute the Value of the Bond Component. 4. Value of the Option Component.
To do this you need to work out the following:
The number of options per bond. The Black-Scholes Value per Option. This calculation includes 5 of the assumptions and data in No 1 (above). I am well aware that we have not touched on option valuations to date. Please give it a shot and we will work through the calculation together in the lecture.
NB. When valuing a convertible debt alternative, it is helpful to consider a plain vanilla bond (just a bond, not a convertible) alternative. The assumptions required (p 5) to work out the yield to maturity for plain vanilla debt are: face value, offer price, maturity, coupon rate, and frequency of payments.
Sensitivity Analysis of Convertible Bond Discount Prepare a sensitivity analysis of the implied offering discount (15.6%) to changes in a) the assumed value of Molycorp common shares, and b) the volatility of its share price. Please use the following inputs:
DCF Value per Common Share: $7.00; $10.00; $11.49; $13.00; $16.00 Volatility: 45%; 50%; 55%; 60%; 65%; 70%; 75%
What do the results of this analysis tell us? See spreadsheet.
