To: CFO, New Earth

From: Group 4 Consulting team: Ka Yan Michelle Au (20344951), Catherine Cho (20337067), Yutong Liu
(20344878), An Li Xu (20341923), Jeffrey Wang (20342506)
Subject: New Earths South Africa Iron Ore Investment Analysis
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New Earth Mining Inc. (New Earth) has substantial investments in the precious metals industry,
specifically gold, but is facing volatile gold prices that may not be sustainable in the future. In response to
this threat, New Earth should consider opportunities to diversify its business through exploration activities
for other minerals.
Attractive Investment for New Earth
New Earth should take the opportunity to invest in the iron ore deposits in South Africa due to the
following reasons: 1) It is a stable investment with long-term prospects of 15 years and a floor price of
$80 per metric ton, and 2) The NPV of the project is $181.75 million, thus providing enough cash flows to
cover debt and provide dividends to shareholders.
Stable Iron Ore Investment
The iron ore investment satisfies New Earths desire to diversify its business from precious metals with
this potential investment life of 15 years. Prices are expected to stay over $80 per ton, with ore prices
having reached a high of over $100 per metric ton in 2012. Production costs are expected to be low due
to the easy access to ports from the mine location, reducing the need for infrastructure investment to
support the development of the mine. Crude steel production in three Asian countries (i.e. China, South
Korea, and Japan) are also expected to grow more than 35% in the next decade, with demand expected
to exceed supply until at least 2016. This is an opportunity to improve the sustainability of New Earth by
investing in less volatile metals and to provide steady cash flows.
However, there are also high political risks of operating in a foreign country like South Africa. Corruption
and the unstable political system are ongoing concerns that pose high risks to NESAs operations,
resulting in large unforeseen costs. New Earth has taken the appropriate steps to mitigate these risks,
acquiring insurance that protects against potential losses due to civil war and government nationalizing
natural resource assets, and setting up various forms of credit guarantees with China, Japan, and South
Korea. Risks of the investment have been properly addressed, but the political environment of South
Africa should still be closely monitored in order to react quickly to potential changes.
Analysis of Project Valuation Approaches
Of the four project valuation approaches, Approach 3 should be used because it evaluates the project
from NESAs point of view as opposed to solely from the equity holders perspective. This is the most
appropriate method because NESA is assuming all the risks and returns for the project. Based on this
approach, the WACC is calculated to be 9.45% (see Exhibit 1).
Approach 1 does not take into consideration that a separate entity is undertaking the investment;
therefore, using New Earths corporate WACC (14%) to discount the project cash flows is not feasible.
Approach 2 takes a more conservative valuation by adding an expected return premium of 10%, resulting
in a WACC of 24%. However, this does not accurately reflect the cost of capital for NESA. Under
Approach 4, the leveraged cost of equity was estimated to be approximately 24%, which is a reasonable
rate due to the risks that this investment brings to New Earth. However, this approach is not appropriate
for this investment because it only takes into consideration the equity holders and does not focus on the
subsidiary as a whole. NESA is the entity taking on the project so its own risks and return is important if
New Earth wants the subsidiary to be profitable.
Financing Package Adds Positive Return on the Iron Ore Project
The financing package will add positive value to New Earth because its NPV is estimated to be $181.75
million (see Exhibit 2). First, the U.S. banks do not require interest to be paid or compounded in the first
two years of investment, reducing the total interest expense to NESA. This positively affects the NPV due
to higher cash flows in early periods.
Second, the $40 million equity financing from New Earth will relieve some of the pressure for debt
repayment on this project. Although this accounts for only 20% of total financing, it does not incur interest
or require repayment at later stages of the project. Also, as per the debt prepayment schedule,
shareholders are unable to receive dividends in excess of the prepayment of debt. This agreement will
reduce agency costs and motivate New Earth to work diligently to generate positive returns and cash
flows for the company.
Lastly, part of the financing package was arranged such that in an event of a cost overrun, the amount of
capital supplied by each lender would automatically increase by up to 25% on a pro rata basis. This
guarantees New Earth for a $240 million investment before having to resort to additional funding.
Potential Risks of the Financing Package for the Iron Ore Project
In addition to the strengths of the financing package, it also has major risks. The project is financed
mostly through debt and the cost of capital is quite high. At a debt to enterprise value ratio of 80%, with
$160 million financed by debt holders, the project will be under pressure to generate the forecasted cash
flows in order to meet debt obligations as well as the interest payments on the debt principal.
The additional 25% funding from lenders is also a potential risk if managed incorrectly. Even though there
is additional financing from debt holders, more debt leads to higher interest payments and more debt
principal payments. Should future cash flows from operations not meet expected projected figures, NESA
will face even more financial distress due to additional debt required to be repaid.
Overall, the value added by the financing package exceeds the potential risks. Since most of the creditors
are also buyers of the iron ore, their goals are aligned with NESA and have vested interest in the success
of the mine. Therefore, despite the highly leveraged position of NESA, there is a great demand for the ore
and the customer network in place minimizes the risk of not realizing the returns expected.
Recommendation to Revise Prepayment Terms
Based on the analysis of cash flows and loan covenant terms, we recommend that prepayment terms be
negotiated. Currently, New Earth is restricted to paying off senior secured debt from US banks and
unsecured debt from Japanese and Korean banks before paying off the junior debt from Chinese
steelmakers. As well, the prepayment of senior debt must be made proportional to the outstanding loan
balance. If both restrictions can be negotiated and removed, New Earth can leverage the varying interest
rates provided by each lender to decrease total interest expense. The $40 million borrowed from the
Japanese and Korean banks have the lowest interest rates at 7%, so it would be advantageous to
negotiate the prepayment terms to repay this loan after the $60 million loan from junior Chinese
steelmakers at 9% is paid.
Below are other components of the financing package that were considered and found to not be of the
highest priority for negotiation:
1. Ore Pricing: This is determined by its commodity price index (i.e. market price). It cannot be influenced
by the company and cannot be easily negotiated with customers.
2. Interest Rate: Since NESA will repay all three loans from U.S., South Korea, and China by 2020, the
amount of interest that NESA has to pay ($67.1 million in total) will have little impact on the companys
cash flows of $800.7 million and pre-tax profit of $924.1 million.
3. Dividends allowed: NESA is highly leveraged so debt holders should have priority over excess cash. It
would not be in the debt holders interest to allow dividends paid to exceed their debt payments.
Furthermore, directing cash to dividends would result in prolonging the outstanding debt, thereby
increasing interest expense and decreasing the total net cash flows to be paid as dividends to New Earth.
4. Debt maturity: Since NESA is planning to prepay all the loans before maturity, the debt maturity has
little effect on the value of the loan liability.
5. Extension of the guarantee program: The current program offered by National Assurance Corp will
cover much of the political risks affecting mining operations in South Africa. Therefore, the extension of
the guarantee program is not a main priority for NESA.
Conclusion
The opportunity to invest in the iron ore deposits in South Africa is attractive for several reasons: the iron
ore body will take 15 years to deplete, making it a viable long-term investment; the price of iron ore is
expected to stay above $80 per metric ton with a steady increase in demand; and the project will provide
positive cash flows with a NPV of $181.75 million. In order to take advantage of the lower interest rates
offered by the Japanese and South Korean banks, the prepayment terms on the loans should be
negotiated. Given the need for New Earth to diversify its business beyond precious-metals, the company
should take on this investment.