Southporth Minerals Case and Solutions

Southport Minerals can be regarded as a company that is the largest sulphur producer in the United States. Rising demand leads considerable expansion in sulphur industry and Southport Minerals enjoyed with the high profitability and extremely liquid with a debt/equity ratio of 0.02. But company wants to decrease dependency to sulphur industry and give prominence to diversification issue and then the company gain the opportunity to develop copper mine in Indonesia. However, the location of the copper mine in terms of political environment can be considered as a risky. In order to realize this project, company should acquire proper financing. In this sense, they are trying to decide how we should determine our cash flows while analyzing the project. Southport decided to proceed project under a subsidiary in Indonesia. They have various reasons for this decision. To exemplify, the translation of currency has great significance. If they proceed under one corporate entity, each transaction will be translated and it may create confusion and discrepancies. Tax regulations in that country is also different so two set of book should be considered for foreign and domestic statements. As we mentioned earlier, political risk is another issue that should be revealed. This method will cause avoid potential distortions by foreign currency conversion.

The first approach to valuing this project is capital budgeting principle. In this approach, decisions are mainly based on cash flows and it doesn’t consider accounting concepts. This concept ignore financing costs but it may be regarded as an unrealistic issue but actually it is not. This is because, in here we know after tax cash flows and when we discount them by the required rate of return, we can come up with net present value. Financing costs are reflected in the required rate of return so there is no need to having financing cost in the cash flows. Otherwise in it will be double-counting. However, this approach should not be used by company because The first approach doesn’t recognize that cash flows to Southport only happen if Southport Indonesia prepays that same amount in debt. This is a mistake because the company only receives cash equal to the amount of the allowable dividend by Southport Indonesia (SI). It ignores financial arrangements(zero npv)

Second approach implies valuing this project with the approach of discounting at a premium. Actually this approach is also has same logic like first one but the discount rate is %20 in this approach and it increases risk premium. WACC in the later years could be 20% due to the capital structure being all equity as debt is paid off, however again this approach doesn’t take into consideration the loan covenant and restrictions on allowable dividends. This approach again ignores financial arragments(negative npv) Namely, using this approach cannot be logical in terms of Southport Mineral.