To: CFO, New Earth From: Group 4 Consulting team: Ka Yan Michelle Au (20344951), Catherine Cho (20337067), Yutong Liu (20344878), An Li Xu (20341923), Jeffrey Wang (20342506) Subject: New Earth’s South Africa Iron Ore Investment Analysis
______________________________________________________________________________ New Earth Mining Inc. (“New Earth”) has substantial investments in the precious metals industry,
specifically gold, but is facing volatile gold prices that may not be sustainable in the future. In response to this threat, New Earth should consider opportunities to diversify its business through exploration activities for other minerals. Attractive Investment for New Earth New Earth should take the opportunity to invest in the iron ore deposits in South Africa due to the following reasons: 1) It is a stable investment with long-term prospects of 15 years and a floor price of $80 per metric ton, and 2) The NPV of the project is $181.75 million, thus providing enough cash flows to cover debt and provide dividends to shareholders. Stable Iron Ore Investment The iron ore investment satisfies New Earth’s desire to diversify its business from precious metals with
this potential investment life of 15 years. Prices are expected to stay over $80 per ton, with ore prices having reached a high of over $100 per metric ton in 2012. Production costs are expected to be low due to the easy access to ports from the mine location, reducing the need for infrastructure investment to support the development of the mine. Crude steel production in three Asian countries (i.e. China, South Korea, and Japan) are also expected to grow more than 35% in the next decade, with demand expected to exceed supply until at least 2016. This is an opportunity to improve the sustainability of New Earth by investing in less volatile metals and to provide steady cash flows. However, there are also high political risks of operating in a foreign country like South Africa. Corruption and the unstable political system are ongoing concerns that pose high risks to NESA’s operations, resulting in large unforeseen costs. New Earth has taken the appropriate steps to mitigate these risks, acquiring insurance that protects against potential losses due to civil war and government nationalizing natural resource assets, and setting up various forms of credit guarantees with China, Japan, and South Korea. Risks of the investment have been properly addressed, but the political environment of South Africa should still be closely monitored m onitored in order to react re act quickly to potential changes.
Analysis of Project Valuation Approaches Of the four project valuation approaches, Approach 3 should be used because it evaluates the project from NESA’s point of view as opposed to solely from the equity holders’ perspective. This is the most
appropriate method because NESA is assuming all the risks and returns for the project. Based on this approach, the WACC is calculated to be 9.45% (see Exhibit 1). Approach 1 does not take into consideration that a separate entity is undertaking the investment; therefore, using New Earth’s corporate WACC (14%) to discount the project cash flows is not feasible.
Approach 2 takes a more conservative valuation by adding an expected return premium of 10%, resulting in a WACC of 24%. However, this does not accurately reflect the cost of capital for NESA. Under Approach 4, the leveraged cost of equity was estimated to be approximately 24%, which is a reasonable rate due to the risks that this investment brings to New Earth. However, this approach is not appropriate for this investment because it only takes into consideration the equity holders and does not focus on the subsidiary as a whole. NESA is the entity taking on the project so its own risks and return is important if New Earth wants the subsidiary to be profitable. Financing Package Adds Positive Return on the Iron Ore Project The financing package will add positive value to New Earth because its NPV is estimated to be $181.75 million (see Exhibit 2). First, the U.S. banks do not require interest to be paid or compounded in the first two years of investment, reducing the total interest expense to NESA. This positively affects the NPV due to higher cash flows in early periods. Second, the $40 million equity financing from New Earth will relieve some of the pressure for debt repayment on this project. Although this accounts for only 20% of total financing, it does not incur interest or require repayment at later stages of the project. Also, as per the debt prepayment schedule, shareholders are unable to receive dividends in excess of the prepayment of debt. This agreement will reduce agency costs and motivate New Earth to work diligently to generate positive returns and cash flows for the company. Lastly, part of the financing package was arranged such that in an event of a cost overrun, the amount of capital supplied by each lender would automatically increase by up to 25% on a pro rata basis. This guarantees New Earth for a $240 million investment before having to resort to additional funding. Potential Risks of the Financing Package for the Iron Ore Project In addition to the strengths of the financing package, it also has major risks. The project is financed mostly through debt and the cost of capital is quite high. At a debt to enterprise value ratio of 80%, with
$160 million financed by debt holders, the project will be under pressure to generate the forecasted cash flows in order to meet debt obligations as well as the interest payments on the debt principal. The additional 25% funding from lenders is also a potential risk if managed incorrectly. Even though there is additional financing from debt holders, more debt leads to higher interest payments and more debt principal payments. Should future cash flows from operations not meet expected projected figures, NESA will face even more financial distress due to additional debt required to be repaid. Overall, the value added by the financing package exceeds the potential risks. Since most of the creditors are also buyers of the iron ore, their goals are aligned with NESA and have vested interest in the success of the mine. Therefore, despite the highly leveraged position of NESA, there is a great demand for the ore and the customer network in place minimizes the risk of not realizing the returns expected. Recommendation to Revise Prepayment Terms Based on the analysis of cash flows and loan covenant terms, we recommend that prepayment terms be negotiated. Currently, New Earth is restricted to paying off senior secured debt from US banks and unsecured debt from Japanese and Korean banks before paying off the junior debt from Chinese steelmakers. As well, the prepayment of senior debt must be made proportional to the outstanding loan balance. If both restrictions can be negotiated and removed, New Earth can leverage the varying interest rates provided by each lender to decrease total interest expense. The $40 million borrowed from the Japanese and Korean banks have the lowest interest rates at 7%, so it would be advantageous to negotiate the prepayment terms to repay this loan after the $60 million loan from junior Chinese steelmakers at 9% is paid. Below are other components of the financing package that were considered and found to not be of the highest priority for negotiation: 1. Ore Pricing: This is determined by its commodity price index (i.e. market price). It cannot be influenced by the company and cannot be easily negotiated with customers. 2. Interest Rate: Since NESA will repay all three loans from U.S., South Korea, and China by 2020, the amount of interest that NESA has to pay ($67.1 million in total) will have little impact on the company’s cash flows of $800.7 million and pre-tax profit of $924.1 million. 3. Dividends allowed: NESA is highly leveraged so debt holders should have priority over excess cash. It would not be in the debt holders’ interest to allow dividends paid to exceed their debt payments.
Furthermore, directing cash to dividends would result in prolonging the outstanding debt, thereby increasing interest expense and decreasing the total net cash flows to be paid as dividends to New Earth.
4. Debt maturity: Since NESA is planning to prepay all the loans before maturity, the debt maturity has little effect on the value of the loan liability. 5. Extension of the guarantee program: The current program offered by National Assurance Corp will cover much of the political risks affecting mining operations in South Africa. Therefore, the extension of the guarantee program is not a main priority for NESA. Conclusion The opportunity to invest in the iron ore deposits in South Africa is attractive for several reasons: the iron ore body will take 15 years to deplete, making it a viable long-term investment; the price of iron ore is expected to stay above $80 per metric ton with a steady increase in demand; and the project will provide positive cash flows with a NPV of $181.75 million. In order to take advantage of the lower interest rates offered by the Japanese and South Korean banks, the prepayment terms on the loans should be negotiated. Given the need for New Earth to diversify its business beyond precious-metals, the company should take on this investment.
