Essay About Major Body Of Iron Ore And New Investment Opportunity

Fins 3625 – New Investment Opportunity in South Africa
BACKGROUND2013 saw the price of gold reach unprecedented heights – rising from $300/ounce to $1700/ounce.New Earth Mining (NEM) was one of the largest US precious metal producers with rapid growth in earningsSimple debt structureReasonable leverage ratio with no significant risk of liquidity.Most mines located in the US and CanadaMade substantial investments in gold exploration projects in other countries such as Australia and ChileThe worry behind the sustainability of gold prices, along with strong financial conditions and the desire to diversify the business through new capital investments, the company started investigating the possibility of diversification in base metals and other materials.NEW INVESTMENT OPPORTUNITY IN SOUTH AFRICAA new investment opportunity appeared in 2012 where NEM decided to evaluate the feasibility and profitability of developing the Kalahari mine.A major body of iron ore close to the massive Kalahari manganese field in the Northern Cape of South AfricaProvided a strategic fit for its diversification objectiveSteel (produced from iron ore) represented 95% of the metal used in the world and arguably more integral to the global economy than other minerals.The price of iron ore had appreciated five-fold from 2002-2012 to above $80 per metric ton (Ex. 2) Gold was highly speculative, whereas iron ore was not exp[ected to fall dramatically given the demand for the commodity.Demand predicted to exceed supply until at least 2016.Long lead timesWorld shortage of labourGrowing national resource nationalism which reduced exportsNEM hired Drexel Corporation to analyse the extent of the deposit and to determine the cost and feasibility of establishing a mine 30 million tonnes of ore with average iron content of 60%2 million tonnes/year extraction rate estimated to last 15 yearsestimated in October 2012 that the proposed venture would be operational at the beginning of 2015 (~2 ¼ years)limited need for infrastructure to support developmenttotal investment cost to be $200 million 40% of investment required at the beginning of 2013 with the rest due at the beginning of 2014includes $20 million in working capitallow production costsat an assumed price of $80/metric tonne, the investment opportunity promised strong cash flows – enhanced by a predictive forecast of $100/tonnesensitivity analysis – Exhibit 4MARKET FOR IRON OREConsumed predominantly by the steel industry – China, Japan, South Korea were among the top countries in both iron ore imports and steel production (Ex. 5)2010 – China imported ~60% of the world’s total iron ore exportscrude steel production expected to grow more than 35% in the next decadeWorld seaborne demand in iron ore had doubled since 2000BHP Billiton – (one of the worlds largest iron ore producers) seaborne iron ore prices predicted to grow steadily over the next decade (4.4%p.a.)SOUTH AFRICARanked 14th in the world in iron ore reserves (2012) – 1 billion tonnes of crude oreRanked 7th largest producer of iron ore in the world (Ex. 5)Most located in the Northern Cape Province in the Kalahari manganese fieldsSaldhanha Bay was on of the primary posts used for export34 million tonnes passing through each yearsignificant construction has been put into building new ports and facilities to satisfy the demand from Asia.Governments of China, Japan and South Korea has provided credit guarantees to mining operationsNEM can protect itself against significant political risk embedded in the South African ventureNEGOTIATING FINANCE PACKAGEDecember 2012 – NEM had tentatively secured a few large steel producers located in China, Japan and South Korea.Iron ore shipped to these countries via seaborne tradeTwo steel producers in china were contractually obligated to purchase half NEM’s Kalahari iron ore output while those in South Korea and Japan were contractually obligated to purchase the other halfPrice settled at the ore market price at the time of the ore shipmentNew Earth South Africa (NESA); a subsidiary of NEM would be the subsidiary undertaking the mining operationTentative negotiations for financing package with potential customers and a syndicate of US banks.Of the $200 million needed to complete the project$100 million tentatively negotiated with overseas buyers$60 million agreed to by two steel makers in China in senior subordinated debt at 9% interest. Loan repayable at $8 million per year between 2022 and 2028, with the final $4 million paid down in 2029 – Guaranteed by the PRCA comparable agreement was arranged with the group of steelmakers in South Korea and JapanA large Japanese bank and Export-Import Bank of South Korea agreed to jointly provide $40 million senior unsecured debt at 7%. Payable between 2016 and 2026 at a decelerating rate (Ex. 6)Guaranteed by the central banks of these countriesThe remaining finance was obtained from domestic lenders$60 million syndicated loan by a group of US banks, repayable between 2016 and 2023 to the NESA.The senior bank loan would carry 10% IR and be collateralised by the mining equipment, which would be purchased from a US manufacturer.Guaranteed by the export facilitating arm of the US GovernmentIn total, $40 million provided at the beginning of 2013 and $120 million worth of loans at the beginning of 2014. The interest accrued in 2013 and 2014 would only be payable in 2015 with no interests compoundingRepayments to be made starting at the end of 2016 (Ex. 6)NEM would invest the remaining $40 million in NESA as equity capital at the beginning of 2013 (Ex. 7).The National Assurance Corp (insurance company backed by the US Government) guaranteed NEM’s investment against potential losses due to civil war and the Government nationalising natural resources assets.NEM struck a deal whereby each party of the proposed $160 million debt financing in the event of a cost overrun, the amount of capital would increase by up to 25% on a pro rata basis for all lenders (Guaranteed $240 million essentially before resorting to additional funding)Loan covenantsAfter deducting interest and contractual debt repayments, NESA would use all remaining discretionary cash flow for prepayments of debt and issuance of dividendsDividend amount was not to exceed prepayment of debtSenior secured and unsecured debt was to be paid in full before junior debtThe actual amount of prepayment to each class of senior debt is proportional to the original amountNo dividends could be pain to NEM until December 31, 2016.Mining operation would be carried out solely by NESA, protecting NEM against potential liabilities. NEM would not have to guarantee, now be responsible for NESA’s debt obligations.PROJECT VALUATIONComplex financing plans created some challenges for NEM in evaluating the investment worth of the new projectFour valuation approached were proposedVP of OperationsDiscounting projected cash flows by NEM’s 14% WACCCost of equity 15%Cost of debt 10%Leverage assumed to be at 12% of the capital structureWith all specifics on financing ignored, and a projected price of iron ore at $80/tonne, the NPV was calculated at $83 million (Ex.4)Accounting OfficerSuggested the new investment carried substantially higher risk than past investments made by the company.Inappropriate to use the company’s cost of capital derived from gold exploration.Based on similar investments made by peer companies in iron ore development in developing countries:Discount projected cash flows at 24% (10% premium)Generates an NPV of -$28 million (Ex. 4)External Consulting FirmStandalone project for the company with unique opportunities and leverage propertiesRequired rate of return on the company’s equity investment would be higher than 14% due to the considerable risksHowever, substantial leverage taken by NEM could result in lower cost of capitalAssumed cost of NESA’s equity to be 24% Internal AnalystThe company should compare the discounted cash flows for equity holders at NESA’s cost of equity (24%) to the equity invested by New EarthThis is known as the flows to equity approachNEM’s relevant investment was $40 million and cash flows consisted of only the dividends to be paid to equity holdersTherefore NEM is completely insulated from the threat of losing more than the equity it had investedA full partitioning of the projected cash flows to debt holders and equity holders had to be estimated (Ex. 7)Schedule the debt amortization with debt prepayment (Ex. 8)This included a faster retirement of debt principle due to the prepayment covenant.