Your team of four people form a financial analysis team at Aussie Finance Consulting (AFC), a renowned

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Question:

Your team of four people form a financial analysis team at Aussie Finance Consulting (AFC), a renowned financial institution. The executive management of AFC has assigned you a task to carry out a special project for its client Whitehaven Coal Limited (WHC), which requires preparing a business report. This report will be presented to AFC executive management and the senior management of WHC. Whitehaven Coal Limited (WHC) is a New South Wales based coal producer, with operations and development projects in The Gunnedah Basin. WHC has a portfolio of producing mines including the Werris Creek Mine, the Narrabri Underground Mine Stage 3 Extension Project, the Maules Creek Project and other projects. The coal mining industry has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for coal. WHC has just been approached by Mid-Cen Electric Company with a request to supply coal for its electric generators for the next eight years. WHC does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in The Gunnedah Basin on 5,000 acres of land purchased 10 years ago for $12 million. Based on a recent appraisal, the company feels it could receive $15.5 million if it sold the land today. Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. Because it is currently operating at full capacity, WHC will need to purchase additional necessary equipment, which will cost $77 million. To get the equipment in running order, there would be a $2 million shipping fee and a $3 million installation charge. The equipment will be depreciated to zero on a straight-line basis over its economic life of 15 years. The contract runs for only eight years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 10 percent of its initial purchase price in eight years. However, WHC plans to open another strip mine at that time and will use the equipment at the new mine. The equipment also requires staff to be specially trained; fortunately, a similar equipment was purchased a year ago, and at that time the staff went through the $500,000 raining program needed to familiarise themselves with the type of equipment. WHC’s management is uncertain whether to charge half of this $500,000 training fee to the new project. The equipment also requires annual maintenance cost of $325,000.The contract calls for the delivery of 500,000 tons of coal per year at a price of $93 per ton. WHC feels that coal production will be 620,000 tons, 680,000 tons, and 730,000 tons, respectively, over the first three years, and 590,000 tons per year over the remaining years. The excess production will be sold in the spot market at an average of $75 per ton in Year 1 with an expected decrease of 2% per annum in the following years. Variable costs amount to $35 per ton in Year 1 with an expected increase of 5% per annum in the following years. Fixed costs are $5,000,000 per year. The mine will require a net working capital investment of 5 percent of sales. The net working capital will be built up in the year prior to the sales. WHC will be responsible for reclaiming the land at termination of the mining. The company uses an outside company for reclamation of all the company's strip mines. It is estimated the cost of reclamation will be $2.5 million. In order to get the necessary permits for the strip mine, the company agreed to donate the land after reclamation to the state for use as a public park and recreation area. This will occur in Year 9 and result in a charitable expense deduction of $15.5 million.

You are required to analyse the project and make recommendations to WHC whether they should take the contract and open the mine.

For the purpose of the analysis, you have already assembled the following information:

Balance Sheet of WHC as of 31 December 2019 Assets
Cash at Bank $121,345,000
Accounts receivable $142,393,000
Inventory $101,884,000
Marketable securities $788,000
Plant, machinery and equipment $4,070,382,000
Intangible assets $22,946,000
Exploration and evaluation $570,194,000
Total Assets $5,029,932,000
Liabilities
Accounts payable $214,564,000
Bank overdraft $550,000
Commercial bills (due 31st Dec 2020) $119,253,000
4.75% Coupon bonds (due Dec 2029 issued @$100 each) $1,439,226,000
Shareholders' Fund
Common stock 1,026,250,427 shares @ $2.927 each $3,003,835,000
Retained Earnings $252,504,000
Liabilities + Shareholders' Fund $5,029,932,000

Additional Information:

The applicable interest rate on bank overdraft is 3.25% per annum and has monthly compounding.
The commercial bills are currently yielding 3.75% per annum with quarterly
compounding. They will mature on 31st December 2020 however, will be replaced by newer issues on that date. Thus, commercial bills may be assumed to run in perpetuity.
The bonds are currently priced at $98 each and pay coupons semi-annually on 30th June, and 31st December.
The coupon payment due to be paid on 31st December 2019 has been paid.
The applicable company tax rate is 30% and the proportion of tax collected from the company and is claimed by shareholders is 0.50.
The current yield on Australian Government 10-year bonds is 1.95% per annum.
The expected market return including franking premium is 8.35% per annum.

Requirements
You are required to advise the company on the following:

a) Capital Budgeting Decision
(i) Should WHC take the contract and open the mine?
Steps in part (a):
The first part of the analysis requires you to work out the Weighted Average Cost of Capital (WACC) for WHC with the help of the given information.
As a part of the WACC calculation, you will need to collect monthly adjusted closing stock prices of WHC and index values of the All Ordinaries Index for the 2015-2019
period from the Yahoo Finance website or MorningStar DatAnalysis Premium database accessed via RMIT library website.

Secondly, evaluate the project using NPV analysis and make recommendation to WHC.

b) Capital Structuring Decision
In the next phase, WHC aims at expanding its operation beyond New South Wales. WHC needs to raise more capital for the purpose. It is advised that the company would be more valuable if it included more debt in its capital structure.

(i) Analyse WHC’s capital structure and give advice with reasonings to the WHC executives if they should use more debt to finance their future expansions.
Steps in part (b):
Determine whether WHC is under or over leveraged relative to the industry. According to Global Industry Classification Standard (GICS), WHC is classified to the Energy sector, the Energy industry group, and the Oil, Gas, & Consumable Fuels industry.

Give your advice with reasonings to the WHC executives if they should use more debt to finance their future expansions. You might want to discuss advantages and disadvantages of using debt financing in your answer. Also consider WHC’s business risk and how it compares with the industry average. Note that a firm’s business risk can be measured as the standard deviation of the firm’s EBIT/TotalAssets over the last five years.

c) Dividend Policy Decision
Another aspect that WHC executives are perplexed about is the dividend policy they should adopt.
(i) Analyse WHC’s dividend payout policy, including discussion of the type of dividend policy employed, changes in dividend payout amounts or patterns, and
the consideration of taxation, dividend imputation and franking credit issues.
WHC’s dividend history can be obtained from the MorningStar DatAnalysis Premium database.

(ii) Given the possibility of WHC significant future expansions, give your advice with reasoning to the WHC executives if they should maintain their current dividend distribution or pursue retention as their dividend policy.

d) Evaluating Leasing Possibility

Instead of purchasing the equipment, your team, being experienced consultants, wishes to propose to WHC that they have another option which is leasing it. Coincidently, your other client, Resolute Leasing Limited (RLL), may be a suitable lessor. On discussions, the executives at RLL have asked you to prepare a lease quotation that could be forwarded to WHC for consideration. For the purpose, RLL has provided the following information:

RLL can get a 20% discount on the purchase price of the machinery.
They expect the life of the machinery to be 15 years with a salvage value of $5 million after that. WHC may use this machinery for eight years, and RLL is confident that it can be leased to others after that.
RLL uses the straight-line method for calculating depreciation.
As the owner of the machinery, RLL is responsible for its annual maintenance cost.
RLL’s effective tax rate is 10%.

(i) If the RLL’s after-tax required rate of return is 10% per annum, what will be the minimum annual lease payment that RLL would charge? Consider that RLL requires lease payments to be made annually in advance.

(ii) Calculate the maximum annual lease payment that would make leasing a viable option for WHC?