Scenario

Your team has been tasked by the executive management to provide careful financial decision analysis in regards to Rio Tinto's latest investment in Western Australia's Pilbara region. This will require preparing a business report which will be presented to the executive management of Rio Tinto.

Background

Read the following article from the Financial Review to get some background.

https://www.afr.com/companies/mining/rio-tinto-invests-1-bn-in-pilbara-iron-ore-mine-20191127-p53ejn

(Or see canvas for a pdf copy)

Rio Tinto is considering a construction proposal to expand the Western Turner Syncline Phase 2 mine. The additional iron ore will feed into Rio's production of the "Pilbara Blend" and maintain its iron ore production capacity for raw materials used to make steel.

However in order to proceed with this expansion, Rio Tinto must construct a new "Crusher", an ammonium nitrate and fuel oil (ANFO) facility, and a 13-kilometre conveyor to link the greater Tom Price site's two mines.

Rio Tinto has undertaken a feasibility study costing $3.2 million to explore their options.

The required tax rate for both options can be found in the details under the balance sheet.

[For simplicity we will assume a project life time of 3 years - that is Year 0, Year 1,

Year 2 and Year 3]

Option 1: Building a "Crusher" and 13-kilometre Conveyor

The construction and installation of a new "Crusher" and 13-kilometre conveyor will cost $23 million. In addition, an ANFO facility will also need to be constructed at a cost $5.2 million. This facility will need to be supplied with slurry pumps, mixed flotation systems and other equipment at a total cost of $5 million. Rio Tinto's reserve fleet of autonomous Caterpillar Haulage trucks will meet the needs for this project, however until recently, the fleet has been earning a rental income of $930,000 per year.

The additional iron ore mined is expected to generate a revenue of $22 million per year, which is forecasted to increase by 2.5% per annum due to higher demand from China. As a result of the additional complexities involved with the construction and management of this project, 7 new engineers (yearly salary per engineer $125,000) will replace 11 existing engineers (yearly salary per engineer $105,000). The 1000 additional construction labour required for this project is expected to cost $4.2 million per annum for the duration of the project. For tax reasons you will expense the cost of the ANFO facility immediately. The cost for the construction of the new "Crusher", 13-kilometre conveyor and associated slurry pumps, mixed floatation systems and other equipment will be depreciated over three years using the straight-line method. Due to the nature of the mining project, the crusher and associated systems and equipment will likely have a salvage value of $11 million at the end of three years. Finally, the required net working capital is $5.2 million which will be returned at the end of the project's lifetime.

Option 2: Outsourcing the supply of ore

Alternatively, to achieve the same iron ore mined from Option 1, Rio Tinto can contract BHP to supply the required iron ore. Based on the amount of iron ore required, BHP has quoted a total cost of $30 million. BHP has however offered this rate on the condition that Rio Tinto pays 20% of the total cost in advance in the beginning of the year (i.e. Y0), with the remaining paid in equal instalments thereafter. Rio Tinto will process the iron ore using existing facilities at an expected cost of $6.8 million per year. Interest expenses related to this project is expected to $2.8 million per year.

[Assume whether sourcing the required iron ore from Option 1 or Option 2, the expected

revenue generated from the additional iron ore is the same]

Your task

Part A: To carry out an analysis, you will need to calculate the appropriate Weighted Average Cost of Capital (WACC). Rio Tinto executive management team are particularly concerned that the WACC be accurate, thus you are expected to determine the WACC based on recent market and other data. (Read below for additional information).

Part B: Carry out a detailed analysis of the two given options and make recommendations to Rio Tinto about those options.

To establish the WACC you have already assembled the following information

Previous year's stock exchange data for the market (ASX200) and for Rio Tinto, adjusted for dividends and capitalization (Price Index). This data is organized in the file: Project Data.xlsx(https://drive.google.com/file/d/16JjxfXlaW83PdfPed0YUQbDYLwwyJPbS/view?usp=sharing). Use this dataset to calculate beta. For CAPM purposes use the return on the market (%) provided in the next section.

Balance Sheet of Rio Tinto as of 31 March 2020

Extract of Balance Sheet for Rio Tinto

Issued Capital $ million

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28,030,000Ordinary shares of $83.0 fully paid 2326.49

6,800,0003.1% Preference Shares of $81.0 fully paid 550.80

Current Liabilities and Provisions

Bank Overdraft 93.00

Trade Creditors 41.00

Unsecured Notes 59.00

Non-Current Liabilities

Debentures 88.00

Term Loans 67.00

Mortgage 91.00

The company's preference and ordinary shares are currently trading at $96.35 each.

The risk-free rate of return is 1.02 % p.a., and the return on the market is 5.70 % p.a.

Debentures have a coupon interest rate of 7.8% p.a. and could be re-issued at the present time at an interest rate of 6.8% p.a. The debentures will be redeemed at their face value in six years' time. Face value is as per the balance sheet.

The mortgage loan is repayable in four years' time and the current interest rate is

5.35% p.a. The mortgage was initially negotiated at 7.30% p.a.

Term loans have a current interest rate of 6.5% p.a., but were negotiated at an interest rate of 7% p.a. They are repayable in full in five years' time. The term loans consists of regular semi-annually interest payments with the principal repaid at maturity

Unsecured notes will mature in 12 months and will not be replaced. They have a current interest rate of 3.23% p.a.

The current interest rate on the bank overdraft is 4.60% p.a.

Interest on all debt securities is paid twice-yearly and the corporate tax-rate is 27 percent.

Your assessment requirements Part A

Calculate WACC:

The first part of the analysis requires you to work out the Weighted Average Cost of Capital (WACC) for Rio Tinto. With the help of the given information and given data, you need to work out the individual costsand value of each of the sources of capital and apply that to the WACC equation to work out the overall weighted cost.

(12 marks)

Part B

Calculate NPV:

Evaluate the two options using NPV analysis and clearly identify which of the two alternatives results in a higher valuation for Rio Tinto. Include your opinion.

Iron Ore price analysis:

Describe in less than a page, your predictions on iron ore prices. Assume due to some event (maybe related to your predictions), the price of iron ore will decrease by 35% per annum during the lifetime of the project. Assume quantity demanded of iron ore during the lifetime of this project remains consistent, would this change your previous analysis? Describe.

(10 + 10 = 20 marks)

Common Questions/Hints:

1. How many items for WACC?

Calculate WACC only on the relevant 6 items as specified in your slides. (Topic 6 - slide 3)

2. Where is the tax rate?

Use the same tax rate under "additional information" (under the balance sheet)

3. Is the second option revenue the same?

Yes.

4. How should I treat the term loan?

A term loan is basically an interest only loan. Thus please use the bond price formula.

5. Working capital?

Working capital should be treated the same as our tutorials- that is an outflow in To and then an inflow at the end of the project's life time.

6. Where is the discount rate to calculate NPV

Calculate WACC!

WACC= required rate of return

See Week 12 modulefor an extensive example on WACC : )

[More will be added if they prop up!]

7. If there are NULL values in your Project Data please delete that whole row of data if excel pops an error. i.e the row containing pricing data for 18/02/2020 please delete.