FIN203 Corporate Finance: FMG Financial Analysis and Project Selection

This report provides a comprehensive financial analysis of Fortescue Metals Group (FMG), an Australian mining company. It assesses FMG's opportunities and threats, including diversification into lithium and concentration risk with iron ore demand from China. The report analyzes the cash conversion ...Read More

CORPORATE FINANCE
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Question 2
a) FMG is an Australian mining company which is primarily into production and supply of
iron ore. It is the fourth largest iron ore producer in the world. The size of operations of FMG
can be gauged from the fact that the area under tenement in Western Australia exceeds that of
both Rio Tinto and BHP Billiton. The operations of the company are concentrated in and
around the Pilbara region in Western Australia. In a bid to diversify, the company has
recently made entry in mining of gold, copper and lithium. Besides, production of iron ore,
the company also has enabling infrastructure with regards to carrying the iron ore from mines
to the port besides having dedicated iron ore carriers to carry the mined ore to destinations
especially in China and Japan.
One key opportunity for FMG is that it could use the mining expertise to venture into other
minerals especially lithium which has immense scope considering the expected boost of
electrical vehicles. One threat for the company is on account of the concentration risk with
iron ore which is dependent on demand from China and hence slowdown from China
adversely impacts the company. Another threat is with regards to environmental concerns
which are raised that can potentially impact production and supply.
(b) The computation of the various elements of the cash conversion cycle have been carried
out as shown below.
The relevant data used for the above computation has been obtained from Morningstar and
summarised below.
The cash cycle or cash conversion cycle has become shorter on reduction of inventory which
may be on account of increase in prices caused by higher demand which may have increased

the offtake. Additional information that would be required would be the amount of offtake to
major destinations such as China and Japan during the two years which would provide more
information.
c) The relevant screenshot from Note 9 is indicated below.
It is apparent that the company is relying on funding through equity which is about 4 times
the total debt on the books of the company. The various advantages of equity based capital
funding are as follows (Parrino and Kidwell, 2014).
 The company does not need to make any repayment of the capital raised and hence
the credit risk and related default risk does not arise.
 The company does not need to pay any interest ensuring that the profitability of the
operations is not adversely impacted.
 Debt based capital funding has debt covenants but these do not exist in equity based
funding and hence allows greater flexibility.
The various disadvantages of equity based capital funding are as follows (Damodaran, 2015).
 The cost of equity is considerably higher than corresponding cost of debt.
 It leads to equity dilution which may adversely impact the control of the promoters
and also the holding of shareholders.
 The tax savings from interest are not reaped.
d) Face value of bond = $ 1000
Coupon rate = 3% p.a.

Annual coupon = (3/100)*1000 = $ 3
Time to maturity = 5 years
The market based interest rate on a similar risk bond is 4% p.a.
The current price of the bond would be the present value of the future cash flows discounted
at 4%. This is exhibited below.
PV of cash flows = FV of cash flows /(1+f)n
Based on the above computation, the current market price of FMG bond should be $ 835.28.
e) If the credit rating of Fortescue bonds is downgraded, then the underlying credit risk
associated with the bonds would increase. Owing to higher risk associated, the expected
returns on the bond would increase and hence the cash flows of the bond would be discounted
at a higher yield which would lead to a drop in the bond price. Since the prices of the bond
would fall, hence the underlying returns would be higher which might make it a lucrative
asset for the investors (Parrino and Kidwell, 2014).
f) The expected returns on FMG stock can be indicated using the CAPM approach.
Expected returns = Risk Free Rate + Beta *(Market Return – Risk Free Rate)
As per the given information, risk free rate = 0.25%, beta = 1.12, return on market portfolio =
9%
Hence, expected returns = 0.25% + 1.12 (9% - 0.25%) = 10.05%
Dividend per share for FMG in 2017 = A$ 0.45 (Obtained from Morningstar)

Current Market Price of FMG share = A$ 3.95
In accordance with Gordon dividend model, the current price of the stock can be indicated
using the following formula (Petty et. al., 2015).
Intrinsic price = Next year dividend/(Cost of equity – Perpetual dividend growth)
3 year operating revenue growth rate = 2.90% p.a.
The above formula would be used to compute the intrinsic price of the stock which then can
be compared with the market price to determine if the stock is currently overvalued or
undervalued.
Intrinsic price = 0.45*1.029/(0.1005 – 0.029) = $ 6.48
Clearly, the current price of the stock is lower than the intrinsic price, hence the share is
undervalued. As a result, it makes sense to purchase the share of FMG at current price
(Damodaran, 2015).
Question 3
a) FMG has a current market capitalisation of AUD 12.295 billion as on September 21, 2018.
The screenshot indicating the same is highlighted as follows.
Source: https://finance.yahoo.com/quote/fmg.ax?ltr=1

The market capitalisation of a company highlights the underlying market value as the formula
for computation involves multiplication of the existing share price and the share outstanding
for the company at particular time. In the light of firming up of the iron ore prices in the
recent tines, it is highly likely that the company would have higher profits in 2018 as
compared to the corresponding profits in 2017. This potentially would lead to an higher EPS
and assuming constant P/E, an increase in the stock price which would lead to increased
market capitalisation (Petty et. al., 2015).
b) The objective of the given assessment is to compare the two capital projects namely
Project A and Project B that the company wishes to evaluate. It is imperative to note that the
price of iron ore has been taken as USD 90/ton as prevalent in March 2017 which would
remain constant over the project life. It is known that all the relevant cash flows tend to
occur at the end of the financial year.
The free cash flows from Project A are given below.
The free cash flows from Project B are shown below.

(ii) Using the above free cash flows, the NPV of the two projects need to be computed using
WACC of 12%.
NPV of Project A (Refer to excel sheet) = USD (560.30 million)
NPV of Project B (Refer to excel sheet) = USD 3823.76 million
(iii) IRR is defined as the underlying discount rate for which NPV becomes zero. The IRR of
the two projects based on the respective free cash flow is highlighted below.
IRR of Project A (Refer to excel sheet) = 10.34%
IRR of Project B (Refer to excel sheet) = 21.40%
Discounted payback period is the time period which is required where the cumulative
discounted cash flow would be equal to the initial investment in the project.
Discounted payback period for project A does not exist since even after considering the 5
years cash inflows, the initial investment is not recovered.
Discounted payback period for project B (Refer to the excel sheet) = 3.78 years

(iv) Considering the above capital budgeting parameters for the two projects (i.e. Project A &
Project B), it is apparent that Project B must be selected. The relevant reasons in this regards
are given below (Damodaran, 2015).
 For project A, NPV is negative. The project NPV should be positive.
 For project A, IRR is less than the cost of capital or WACC. For a feasible project,
IRR should be greater than WACC.
 For project A, discounted payback period does not exist. For a feasible project,
discounted payback period must be lesser than the project useful life.
(v) Even if $ 100 million are obtained by asset sale, then also the decision would not change
since the respective capital budgeting measures associated with Project A would still be
inferior to Project B. As a result, Project B would still be the preferred project (Parrino and
Kidwell, 2014).

References
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia