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Determination of the cost of the various sources of costly

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Reference no: EM131059669

RESEARCH PROJECT -

FINANCIAL MANAGEMENT POLICY DETERMINATION AND STRATEGIC DECISION-MAKING FOR FORTESCUE METALS GROUP LIMITED

Your investment banking firm has been contracted by Fortescue Metals Group Limited (ASX Code: FMG) to provide an independent assessment of their current financial management policy selection and decision-making, and a recommendation regarding the optimal capital budget for the company for the 2015 financial year and incorporation of this capital budget decision-making within the existing financial management policies of Fortescue Metals Group Limited. The focus of this task should be on using information sources, such as the 2015 Annual Report, prior year annual reports and other relevant documentation, to identify and explain the financial management policies adopted by Fortescue Metals Group Limited. The final component of your project should be an investment evaluation application and the provision of strategic advice regarding the implementation and funding of the recommended capital budget in the context of the current financial management policy settings of Fortescue Metals Group Limited.

Fortescue Metals Group Limited is a leading iron ore production and exploration company which operates in the Pilbara region of northern Western Australia. The company is the fourth-largest listed resources company in Australia, behind BHP Billiton Limited, Rio Tinto Limited and Woodside Petroleum Limited, and the largest pure-play iron ore mining company listed in Australia. For a company overview please see https://fmgl.com.au/about-fortescue/company-overview/.

The detailed overall summary, structural and performance information can be obtained from the 2015 Annual Report document for Fortescue Metals Group Limited. This annual report and prior year annual report documents can also be obtained from the Fortescue Metals Group Limited web-site (www.fmgl.com.au) or from the DatAnalysis Premium database available through the Databases link on the University Library web-site. Other relevant financial information relating to Fortescue Metals Group Limited or the wider corporate sector is as follows:

- Assume that this analysis is being undertaken at July 1st 2015 (the beginning of the 2016 financial year).

- Fortescue Metals Group Limited is a part of the Materials Sector, based on the Global Industry Classification Standards (GICS) Sector Groupings. Fortescue Metals Group Limited's beta coefficient is 0.89, compared to the beta coefficient for the overall Materials industry sector of 1.04.

- The market risk premium is estimated as 3%.

- The Australian dollar to US dollar (AUD/USD) exchange rate on July 1st 2015 was 0.7713.

- Three month LIBOR rate on U.S. dollar was 0.2836% per year on July 1st 2015

- Fortescue Metals Group Limited has a corporate tax rate of 30%.

The required tasks associated with this research project are, based on using the information within the annual report documentation and any other documentation or

sources of information considered to be relevant, to identify and outline the following aspects of Fortescue Metals Group Limited's financial management policy:

1) The nature of the firm's working capital management policies. Focus in this determination should be on overall current asset investment and financing policies, rather than the company's adoption of policies relating to specific current asset categories, such as inventories or receivables.

2) Determination of the cost of the various sources of costly (interest-bearing) financing used by the firm and, based on this information, Fortescue Metals Group Limited's overall weighted average cost of capital (WACC).

3) The nature of the firm's earnings distribution and dividend payout policies. This should include discussion of the type of dividend policy employed, whether the firm has an identifiable target dividend policy or payout ratio, changes in dividend payout amounts or patterns, and the consideration of taxation, dividend imputation and franking credit issues and wider elements associated with the firm's overall earnings management and distribution practices.

4) The nature of the firm's capital structure determination policy, including identification of specific policy adoption or usage if relevant, whether the firm appears to have target or optimal capital structure ratios, and the determinants of the firm's capital structure choice.

5) Assuming the following information about different projects of the company, conduct a quantitative assessment of Fortescue Metals Group Limited's capital budget and provide a recommendation of the optimal capital budget for the company for the 2016 financial year and an analytical justification for how the optimal capital budget should be funded and any implications of this for their current financial management policies in place.

Capital Project: Development of the Fortescue River Gas Pipeline and Gas Conversion of the Solomon Hub Power Station

- This project is centred on reducing energy costs and carbon emissions by converting the fuel source for the operation of the Solomon Hub Power Station from diesel fuel to natural gas. The project will require the construction of the 270 kilometre Fortescue River Gas Pipeline, which will connect with the existing Dampier to Bunbury Natural Gas Pipeline to provide for delivery of natural gas to the Solomon Hub Power Station.

- The project cost is estimated at $265,000,000.

- Operation of the power station using natural gas rather than diesel fuel is expected provide after-tax savings, not including depreciation deductions, of $20,000,000 per annum.

- Fortescue Metals Group Limited can claim annual straight-line depreciation deductions against the cost of construction of the gas pipeline over a 20-year useful life period.

- The risk classification for this project is: Average Risk.

Capital Project 2: Acquisition of BC Iron Limited

- BC Iron Limited is a listed iron ore development and mining company operating the Nullagine Iron Ore Project in the Pilbara region of Western Australia.

- Based on the $0.30 share price and 196,196,992 shares on issue for BC Iron Limited on July 1st 2015, an expected successful takeover offer price of $0.39 per share.

- Estimated synergies of $16,000,000 in additional annual after-tax net profit are expected immediately following the acquisition, which will grow at 1.80% per annum in the future.

- Deal completion costs are estimated at $5,000,000.

- The risk classification for this project is: Above-Average Risk.
Capital Project 3: Upgrade of the Rail Infrastructure at the Christmas Creek Mine

- Project cost is estimated at $200,000,000.

- Fortescue Metals Group Limited can claim annual straight-line depreciation deductions against the project upgrade cost over a 20-year useful life period.

- The risk classification for this project is: Below-Average Risk.
Capital Project 4: Development of the Western Hub Region which has an indicated resource base of 624 Million tonnes (Mt) of iron ore.

- The project will be developed over a multiple-year period. Annual project development costs are estimated to be $2,200,000,000 during 2016,
$2,600,000,000 during 2017 and $1,600,000,000 during 2018 (the costs are at the beginning of each year).

- The Western Hub Region Project is expected to produce 42 Million tonnes of iron ore each year of its 15-year life, with the first year of iron ore production expected to be at the end of 2018.

- The average iron ore spot market price over the 15-year life of the project is expected to be $85 per tonne.

- Cash operating costs of the mine are estimated at $50.00 per tonne before tax.

- Fortescue Metals Group Limited can claim straight-line depreciation deductions against the cost of construction of the Western Hub Region Project over a 15-year useful life period. Depreciation deductions will be claimed against the operation of the project starting at the end of 2018.
- The risk classification for this project is: Above-Average Risk.

The risk-adjustment criteria employed by Fortescue Metals Group Limited are as follows:

- Below-Average Risk projects: Company WACC - 1.00%

- Average Risk projects: Company WACC

- Above-Average Risk projects: Company WACC + 2.00%

Working together. Delivering results.

ABN 57 002 594 872 | 2015 Annual Report

Reference no: EM131059669

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