7/22/2019 287922_1_FINACE1 (1)

1/2

NewEarthMining,Inc.1

Based in Denver, New Earth Mining is one of the largest U.S. precious-metal

producers, and has experienced significant growth in the last decade, mainlydue to increasing gold prices (from $ 300 to $ 1,700 per ounce). New Earthexecutives worried about the sustainability of gold prices at their current levels.The company felt it was necessary to implement a diversification program thatwould reduce its dependence on precious metals. Therefore, New Earthrecently started investigating the possibility of diversification in base metalsand other materials.

A new investment opportunity appeared in early 2012. New Earth wasinformed of the existence of a major body of iron ore close to the massiveKalahari Manganese field in South Africa. The company felt that an

investment in iron ore provided a strategic fit for its diversification objective.

The price of iron appreciated more than five-fold from 2002 to 2012, but wouldprobably fall by about 20% to $ 80 for the project lifetime. New Earth hiredDrexel Corporation, an engineering and construction firm, to analyze theextent of the deposit and to determine the cost and feasibility of establishing amine site close to Kalahari. The engineering firm found that the field contained30 million tons of ore with an average iron content of 60%. At the projectedextraction rate of 2 million tons per year, it would take 15 years to deplete theore body.

Drexel estimated that the proposed venture in South Africa could beoperational by the beginning of 2015. The total investment in infrastructure tosupport the development of the mine would be $ 200 million, with 40% of theinvestment required at the beginning of 2013 and the remaining required atthe beginning of 2014. These investments would be made in South AfricanRand (ZAR) and would include construction costs and related insurance,operational costs, and $ 20 million in working capital.

By November 2012, New Earth was able to produce a pro forma analysis ofthe profitability of the new investment. This is shown in the cash flow analysis"Cash Flows" in the attached spreadsheet. Since iron is sold in theinternational market, the revenues will be in US Dollars (USD), but all costsfor operating the mine will be ZAR. Taxes will be paid in the U.S. All numbersin the spreadsheet "Cash Flow" have been converted to USD.

By December 2012, New Earth had tentatively secured a few large steelproducers located in China, Japan, and South Korea as major customers. IronOre would be shipped to these countries via a South African shippingcompany. New Earth also negotiated a financing package with the potentialcustomers and a syndicate of U.S. banks. The financing package consisted of

1

This case is a summarized and adapted version of Harvard Business School Case 9-913-548, "New Earth Minin, Inc.", 2013, by W.E. Fruhan, and W. Wang.

7/22/2019 287922_1_FINACE1 (1)

2/2

three loans, totaling $ 160 million. The remaining $ 40 million would beprovided as equity by New Earth itself, paid from its cash position. As therevenues from the venture would be in USD, the loans would also be given inUSD. The spreadsheet "Debt" shows when the loans would be provided aswell as the repayment schedule. The senior secured and unsecured debt

would be normal coupon-paying debt, whereas the senior subordinated debtwould be a zero-coupon loan, implying that in 2024 both the principal of $ 60million as well as the accrued interest would be paid.

The spreadsheet "Market Rates" shows current interest rates in the U.S. andSouth Africa, the exchange rate, the iron price, as well as stock market data.

New Earth wants to answer the following questions:

1. What is the net present value of the project? (They wonder whether theWACC or the APV methodology is the right approach.)

a. Briefly explain why you recommend WACC or APV.b. Calculate the appropriate discount rate.c. Calculate the net present value of the project.d. Calculate the value of the tax shield from the loans.

2. As part of the investment needs to be made early 2014 in ZAR, thecompany wants to hedge the exchange rate. They wonder whetherthey should hedge using a forward contract or an option contract.

a. At what forward price can they hedge the investment?b. What would be the cost of an at-the-money option?c. Which hedge strategy do you recommend?

3. They also wonder whether they should hedge the ZAR/USD-risk in thecash flows from the venture. If they decide to hedge, should theyhedge the entire cash flow or only part of it? And if only partly, whichpart of the cash flow should they hedge?

4. For the years 2024-2029, what is your estimate of the volatility of thecash flow (in percentage)? (If you cannot answer this, use 35% as anestimate in the next question.)

5. The senior subordinated debt needs to be repaid in 2024 ($ 30 millionplus compounded interest). Using the option approach to value debtand equity, what is the value of the subordinated debt at the beginningof 2013 and what is the implied cost of this debt? Hint: note that when

repaying the debt in 2024, the venture will last for five more years. It isthe present value of these last five cash flows that is the underlyingvalue of the option.

You are asked to write a short management report addressing the questionsabove. Please that the report is clear in itself, but you can add a spreadsheetwith more detailed calculations.

Note that the spreadsheet contains the option functions =bscall(), =bsput(), =fxcall(), and fxput().