Capital Structure and Investment Appraisal of Rio Tinto

This report provides a critical assessment of the capital structure of Rio Tinto, a leading metal mining company. It covers the sources of finance, types of reserves, and nature of borrowings. The report also discusses various methods of capital appraisal used by the entities before entering into a capital expenditure contract. The assessment is based on the figures provided in the latest consolidated balance sheet of the year ended on 31st December 2017.

July 2nd, 2018
Business Analysis and Decision Making
RIO TINTO

REPORT 1
Executive Summary
The company selected for the report is Rio Tinto. The company operates in the metal
mining sector with its dual head offices at UK and Australia, the shares being also dually
listed on the London Stock Exchange and the Australian Stock Exchange. The report is a
critical assessment of the capital structure of the company, the various sources of finance, and
a discussion on the various methods of capital appraisal utilized by the entities in order to
make the capital expenditure successful. The assessment is based on the figures provided in
the latest consolidated balance sheet of the year ended on 31st December 2017. The balance
sheet of the company shows strong position with an improvement in the capital-gearing ratio
of the company as compared to the previous year; the same has been depicted by computing
the related calculations.

REPORT 2
Table of contents
Introduction................................................................................................................................3
Analysis of capital structure.......................................................................................................3
Assessment of sources of finance..............................................................................................4
Methods of capital investment appraisal....................................................................................5
Net Present Value (NPV).......................................................................................................5
Profitability Index (PI)...........................................................................................................6
Internal Rate of Return (IRR).................................................................................................6
Accounting Rate of Return (ARR).........................................................................................7
Pay Back Period.....................................................................................................................7
Conclusion..................................................................................................................................8
References..................................................................................................................................9
Appendix..................................................................................................................................11

REPORT 3
Introduction
Rio Tinto is one among the companies engaged in mineral and metal mining industry
and is regarded as one of the world’s largest conglomerate, the chief mined commodities
being copper, aluminium, iron ore, uranium, coal and diamonds. The company has dual head
offices in UK and Australia (Rio Tinto, 2018a). The company operates in the UK as Rio
Tinto plc, the shares of which are listed at the London Stock exchange where it is a part of the
FTSE 100 Index, and as Rio Tinto Limited in Australia, the shares of which are traded at the
Australian Securities Exchange. The capital structure analysis of the company Rio Tinto is as
follows.
Analysis of capital structure
The number of the ordinary total issued and the paid-up shares on the 31st December
2017, the company Rio Tinto plc were 1351.609 million (Rio Tinto, 2018b). The amount of
share capital as on that date was US $ 220 million. Out of which the shares held by the public
are 1342.058 million and the shares held in the treasury are 9.551 million (Rio Tinto, 2018b).
There are three other classes of the shares i.e. firstly the Special Voting Right Share, DLC
Dividend Share, and Equalisation Share. A brief analysis of the various types of the
consolidated reserves and the retained earnings of the company is as follows. There are five
categories of the reserves namely the capital redemption reserve, foreign currency translation
reserve, hedging reserves, sale revaluation reserves, and the cumulative other reserves. The
balance in the Capital redemption reserve as on 31st December 2017 was US $ 38 million.
The balance in the Hedging reserves as at the end of the financial year 2017 was US $ 32
million and the balance of the sale revaluation reserves after all the adjustments was US $ 20
million. The balances of the Foreign currency translation reserve and the cumulative other

REPORT 4
reserves were US $ 480 million and US $ 11714 million respectively. The retained earnings
amounted to US $ 23761 million. The total borrowings and the other financial liabilities out
of the non-current liabilities amounted to US $ 15148 million.
Assessment of sources of finance
The net debt amounts to 2869 Pound Sterling or US $ 3845 million or US $ 3.8
billion and the total equity amounted to US $ 51115 million (Rio Tinto, 2018). And therefore
the net gearing or the net debt to the total capital accounts for about 7 percent, as on the year
ended on 31st December 2017 (Rio Tinto, 2018). The net gearing has been calculated using
the following formula.
Net Gearing = Net Debt
Total Equity
Which implies, net gearing of Rio Tinto (in US $ million) = 3845/ 51115 = 7 %
The net gearing has improved from the last year which was 17 percent. The net debt
has decreased from US $ 9.6 billion in the year 2016 that accounts for the decrease of about
60 percent. The major reason being, operating cash inflows and the proceeds from the
disinvestment activities were offset by the cash returns to the shareholders and the capital
expenditure activities. The interest cover for the year 2017 was 14 times as compared to 7
times of the last year. (Rio Tinto, 2018). The decrease in the net debt and the improvement in
the interest cover are strong indicators in the balance sheet of Rio Tinto. Borrowings and
other financial liabilities are initially recognised by the company at fair value, i.e. net of
transaction costs incurred by the entity. The same are later on measured at the amortised cost.
The total short terms borrowings and bank overdrafts amounted to US $ 552 million. The
medium and long-term borrowings amounted to US $ 14624 million. The cash and cash
equivalents at the yearend stood at US $ 10550 million. As per the group cash flow statement,

REPORT 5
the repayment of the borrowings during the year amounted to US $ 2795 million. The cash
and cash equivalents as on 31st December 2017 were US $ 10550 million.
Methods of capital investment appraisal
The five major techniques of evaluation of the capital appraisal projects are described
below, i.e. NPV method, profitability index method, internal rate of return method,
accounting rate of return method and payback period method.
Net Present Value (NPV)
The method uses the important concept of the time value of money. The cash flows
arising out of the operations over the years are first discounted and then in the next step, these
are compared with the initial capital investment amount. In order to determine the NPV, the
following formula is used (Brigham and Houston, 2012).
NPV=∑
i=1
n CFi
(1+ d)i
= CF0 + CF 1
(1+k )1 + CF 2
(1+k )2 + …. + CF 3
(1+k )3
where:
CFi = net cash flow from year i,
CF0 = initial investment,
k = discount rate, and
n = number of years.
The few of the benefits of the method of investment appraisal are consideration of an
important comncept of finance i.e. the time value of money, consideration of both pre and the

REPORT 6
post-project cash flows and taking into account the risks associated with each of the projects
while comparing more than one projects. (Gallo, 2014). The weaknesses are that the method
is complicated, it is complicated to compute a suitable discount rate and the results may not
be useful in case of comparison of the projects with unequal lives.
Profitability Index Method (PI)
This technique of capital appraisal measures the ratio between the amount of the
initial investment and the cash flows occurring later on. And therefore, the formula for PI is
as follows-
Profitability Index = Present value of future net cash flows
Initial Investment
The capital appraisal method is helpful when the initial capital investment is of a
limited amount (Rὂhrich, 2014). The similarity of the method with that of the NPV method
refers to similar advantages. The weakness of the technique it doesn't lead to an appropriate
capital rationing in case of the indivisible projects.
Internal Rate of Return Method (IRR)
The IRR method is similar to the NPV method. The internal rate of return represents
the interest earned by the entity on the capital employed at various points of time in relation
to the investment proposal concerned (Arjunan, 2017). IRR can be determined by using the
following formula:
IRR= 𝑑l + NPV at Dl
NPV at Dl - NPV at Dh❑
× d ifference in discount rates,
Where dl = lower discount rate and
dh = higher discount rate.

REPORT 7
The key benefit of the technique is that the method considers the time value of the
money. The major disadvantages are that the method works on the reinvestment assumption
that the intermediate cash flows arising are invested at the same rate as that of the IRR.
Accounting Rate of Return Method (ARR)
The calculation of the ARR is done in two steps. Firstly, by dividing the expected net
operating profits of the organisation by the initial investment. Secondly, the result of the
above calculation is then compared with the top management's pre-decided rate of return.
Accordingly, a capital appraisal project is accepted or rejected (Corporate Finance Institute,
2018). And therefore, the ARR can be calculated by using the below mentioned formula.
Accounting rate of return = Net operating profits
Initial Investments
The benefit of this method is the simplicity to perform and the consideration of the
accounting profits unlike in the other methods (Scott, 2012). The weakness is avoidance of
the time value of money and the results are described in the ratio form instead of the actual
profits; as a result, information can be misinterpreted.
Pay Back Period Method
The time in which the cash inflows of any proposal becomes equal to the initial
capital investment of the project is the payback period (Prakken, 2012). The formula for
payback period is as follows.
Payback period = Cost of the project/ Annual cash inflows
The advantages of this capital appraisal technique are that it is easy to understand and
the liquidity is considered. The major disadvantage is non-consideration of the time value of
money (Lane and Rosewall, 2015).

REPORT 8
The company Rio Tinto recognises the importance of the capital expenditure and how
it is necessary to sustain the productive capacities of the already installed asset base for the
growth and the development. The company states that it follows a rigorous investment
process that involves prudent assessment practices and the same are selected only if attractive
returns are offered over and above the cost of capital. The company’s total capital
expenditure during the year 2017 was US$4.5 billion. The major capital project in the year
2017 was the development of underground copper mine of Oyu Tolgoi and the construction
of infrastructure at Amrun bauxite project (Rio Tinto, 2018).
Conclusion
As per the analysis in the previous sections, following conclusions can be established
that the capital structure, sources of finance, types of reserves, nature of borrowings are
important components of the balance sheet of the entity. In addition to these, there are various
methods of capital appraisal used by the entities before entering into a capital expenditure
contract, to assess the viability of the same. Each of the methods has its own share of pros
and cons. As discussed, Rio Tinto’s overall capital is divided into two major heads as Rio
Tinto plc and Rio Tinto Limited. There are various kinds of reserves along with varied
sources of finance. The capital structure has improved as that from the last year as depicted
by the gearing ratio. In addition, the company has considered few major capital investments
this year for the overall development and growth of the entity.

REPORT 9
References
Arjunan, K. C. (2017). A New Method to Estimate NPV from the Capital Amortization
Schedule and an Insight into Why NPV Is Not the Appropriate Criterion for Capital
Investment Decision. Retrieved from:
file:///C:/Users/System04100/Downloads/SSRN-id2899648.pdf
Brigham, E. F., and Houston, J. F. (2012). Fundamentals of Financial Management. Boston
MA: Cengage Learning.
Corporate Finance Institute (2018). ARR- Accounting Rate of Return. Retrieved from:
https://corporatefinanceinstitute.com/resources/knowledge/accounting/arr-accounting-
rate-of-return/
Gallo, A. (2014). A refresher on net present value. Harvard Business Review. Retrieved from:
http://www.cogencygroup.ca/uploads/5/4/8/7/54873895/harvard_business_review-
a_refresher_on_net_present_value_november_19_2014.pdf
Lane, K., and Rosewall, T. (2015). Firms’ investment decisions and interest rates. Reserve
Bank of Australia Bulletin. June quarter. Retrieved from:
https://www.rba.gov.au/publications/bulletin/2015/jun/pdf/bu-0615-1.pdf
Prakken, B. (2012). Information, Organization and Information Systems Design: An
Integrated Approach to Information Problems. New York: Springer Science and
Business Media.
Rio Tinto. (2018a). Corporate Governance. Retrieved from:
https://www.riotinto.com/aboutus/corporate-governance-22039.aspx

REPORT 10
Rio Tinto. (2018b). Annual Report 2017. Retrieved from:
https://www.riotinto.com/documents/RT_2017_Annual_Report.pdf
Rὂhrich, M. (2014). Fundamentals of Investment Appraisal: An Illustration based on a Case
Study. Boston: Walter de Gruyter GmbH & Co.
Scott, P. (2012). Accounting for Business: An Integrated Print and Online Solution. Oxford:
Oxford University Press. 342.

REPORT 11
Appendix
Calculation of Total Equity
Total Equity = Share Capital + Share Premium Account + Other Reserves + Retained
Earnings + Equity Attributable to non controlling interests
Therefore, Total Equity (Amount in US $ million) = 220 + 4140 + 4306 + 12284 + 23761 +
6404
Total Equity = US $ 51115 million.