Southport Minerals Case Study

1. Southport Minerals will consider its NPV through four kinds of approaches. We think that Approach 4 is the most reasonable method to calculate the project’s NPV.

The first and second approaches only consider the cost of equity without considering the cost of debt. Especially, in this case, they have $100 million debt over total $120 million investment. Furthermore, since these debts has quite a low interest rate and is guaranteed by third party, the cost of capital should not be as high as 15% or 20%, which will highly undervalue the NPV of this project.

Approach 3 computes Weighted Average Cost of Capital which is 7.6%. It is more reasonable than the above two approaches. However, we found out the cost of equity is tax deductible in its calculation, which is strange. We think that the equity cost is not a tax-deductible expenditure and should not times (1-Tax rate). Based on our assumption, the WACC should be 9.8% instead of 7.6%.   Also, the capital structure of Southport Minerals is changing during the project period. E/V ratio and D/V ratio is different from year to year. Therefore, this WACC is not estimated accurately.

We think the Approach 4 is the most reasonable one.  Because in this case, Southport does not need to bear the debt risk, all its debt is guaranteed by bank, the only thing that need to be considered is the $20 million equity investment. If we only consider equity investment, it is reasonable to use cost of equity to discount the cash flow of the project.

1. In this case, the main risk that Southport will face is the change of the copper price and the risk of expropriation. The assumed price of the Firstburg investment for refined copper is 40 Cents/lb. but from Table A, the price can go down to 24.8 Cents/lb. If this situation appeared, the revenue will reduce and the profitability will lower than the assumption. In addition, the risk of expropriation from the government, therefore, the parent company has risk of losing $20 million investment.  In approach 4, with the negotiation, Southport bear less risk by passing $100 million financial risk to the guarantors. In this approach, Southport just bears $20 million of equity.

The specific financing choice will alter the return of the investment too. From the exhibit 8, Southport is required to repay debt in the early year of the project (from 1973 to 1979). Since the early repayment will cause the higher present value compared with the later repayment, lower return Southport will get.

1. We will put emphasis on the interest rates and debt maturities if we need to negotiate an improvement.

If the interest rates can be a little lower than the current rate, the burden on the debt will be smaller, which in turn leads to a higher return.

Regarding to debt maturities, the company may prefer to repay the debt as late as possible as a borrower. Since the long-term maturities can help to increase the working capital during the debt holding period, it would further increase the return of the project because the present value of the repayment of the debt will be lower.

As to the price term, price of copper is relatively difficult to negotiate because it depends on the market price. Compared with the interest rates or debt maturities, it is not an appropriate strategy for Southport Minerals to implement.