FIN5FMA Research Project : Financial Management Assessment

Financial Management Assessment

Case Scenario/ Task

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.

We are pleased to present you this report on financial management of Fortescue Metals Group Limited, an Australian company engaged in iron ore production, mining and production. In the report, we discuss about company’s working capital management policies and with emphasis on current asset investment and financing policies. The report highlights various sources of finance used by the company and computation of weighted average cost of capital (WACC). The report discusses firm’s earnings distribution and dividend payout policies with focus on identification of target dividend policy and payout ratio (Anthony L, Elven R, 2013). In addition, factors affecting capital structure and identification of optimal capital structure. The report has recommendations of optimal capital budget for 2016 financial year with analytical justifications on funding and implications of company’s existing financial management policies.

1. Working Capital management policies

Working Capital reflects company’s short term financial health and efficiency. Working Capital equates to Current Assets minus Current Liabilities. It is always possible that an organization can have high profitability levels but short of liquid assets. An organization has to meet short term obligations for ensuring smooth functioning of the business. Current assets or liquid assets can easily be converted into cash for paying off short term obligations. In this section, we highlight nature of working capital management policies adopted by Fortescue Metals Group Limited.

The company’s total current assets comprise cash, cash and cash equivalents and short term investments, receivables, inventories, prepaid expenses and other current assets. On the other hand, company’s current liabilities includes accounts payable, short term debt, capital leases, deferred income taxes, deferred revenues and other current liabilities. We analyze the company’s working capital from financial year 2011 to gain an insight about current asset investment and financing policies. The following table highlights current assets, current liabilities and working capital (AUD in millions):

The above table shows that the company has maintained high amount of current asset investment in the last five financial years. The company’s total current assets have been far higher in comparison to company’s total current liabilities. This has resulted in a net positive working capital for the company. The working capital range in the last 5 financial years has been 1.282 billion AUD to 2.423 billion AUD. Fortescue Metals Group Limited has mostly keep its current assets in cash and cash equivalents. This highlights that the company is well aware of the short term fund requirements and is not ready to compromise liquidity even at the cost of profitability. The key analytical point remains funding of short term assets and how the company has been able to mange such high cash levels (Anna J, Tina K G, 2013). The current asset investment has been largely on back of long term financial policies pursued by the company. The company has used long term debt for financing short term working capital requirements.

The below table highlights company’s long term debt for the last five financial years:

Analysis reveals that the company does not hesitate to raise long term debt for meeting both long and short term capital requirements. In other words, the company uses long term financial policies for making current asset investment. Thus, the current working capital management policy pursued by the company is not conducive. This is because of the fact that the company raises long term debt at an interest rate which is higher than the rate of return on short term current asset investments. In addition, maintenance of such high cash levels by the company results in non-materialization of lucrative business opportunities. The opportunity cost involved in working capital management is higher since the company is unable to use the cash for investments in other long term projects for earning higher rate of return for shareholders. From management’s point of view, such high cash levels may be due to cyclical nature of business, liquidity position of global credit markets and company scouting for both organic and inorganic growth plans. It becomes difficult to concur with management’s view on nature of working capital management policy practiced by the company (Constantinos L, Anastasios T, John L, 2014). However, it is recommended that the company should have lower cash levels for effective working capital management. In this way, Fortescue Metals Group Limited would be able to use the existing cash levels in other long term projects and would not need to raise additional debt for funding short term requirements.

2. Weighted Average Cost of Capital

Fortescue Metals Group Limited uses both debt and equity to fund capital requirements. The following table depicts capital structure of the company comprising of debt and equity at the end of 2015 financial year:

The company’s interest bearing sources of finance includes the following:

The following table highlights interest expense for 2015 financial year on different debt instruments:

Thus, coupon rate on following debt instruments equates to:

The following table depicts capital structure along with weights of debt and equity:

Thus, for computation of weighted average cost of capital (WACC) of the company, both debt and equity cost should be calculated separately and subsequently added.

First, we calculate the tax rate for the company which is computed as below:

Profit before income tax (in USD million) = 420

Income tax expense (in USD million) = 104

Tax rate for the company = 104/420*100 = 24.76%

The following table highlights calculation of weights of different debt instruments and equity in capital structure:

Therefore, pre-tax weighted costs of each debt instrument equal to

After tax-after weighted costs of each debt instrument equal to:

Therefore, after tax weighted average cost of debt for the company equals to = 0.98%+1.41%+ 0.20% = 2.60%

Cost of Equity = Rf + (Rm- Rf)*b

Where, Rf = Risk free rate of interest in Australia

Rm- Rf = Market risk premium = 3% (given)

b= Beta coefficient = 0.89

Therefore, Cost of Equity = 2.6+ (3*0.89) = 2.6+2.67 = 5.27%

Thus, weighted average cost of capital (WACC) of Fortescue Metals Group Limited = 2.6%+ (0.44*5.27%) = 2.6%+2.32% = 4.92%

3. Dividend payout policies

Dividend payout policies refer to set of guidelines used by organisations for deciding payout of earnings to shareholders. The company’s dividend payout policies may or may not include an identifiable target dividend policy or payout ratio. Fortescue Metals Group Limited has been constantly rewarding shareholders in the form of dividends in the last five years. The company’s dividends have fluctuated in line with company’s net income (Erika M, Daniel S, 2015). Higher net income has resulted in absolute higher dividend payout to shareholders and vice-versa. Thus, company’s net income has affected company’s ability and dividend decision paying policy. The below table shows net income and dividend per share for the last 5 financial years:

Thus, from the above table, we observe that with declining company’s profitability, Fortescue Metals Group Limited has decreased dividends payout to shareholders. Thus, the company does not have an identifiable target dividend policy or payout ratio. However, the company considers following elements associated with firm’s earnings management and distribution practices in formulation of dividend policy:

• Legal Requirements: There is no legal compulsion on part of company’s management to announce and pay dividends to shareholders. Thus, Fortescue Metals Group Limited’s management is free to decide and pay dividends to shareholders based on their decision. The company management’s announces dividends based on company’s current profitability, forecasted future profitability, capital expenditure requirements and other financing activities.

• Firm’s liquidity position: Fortescue Metals Group Limited has maintained strong liquidity position in the last five financial years. The company has adequate current assets to pay off current liabilities. In addition, the company has maintained huge working capital to meet short term fund requirements (Geoffroy E, Robert K, 2012). Higher cash level in the balance sheet is one of the reasons that the company has been paying dividends despite falling net income. However, absolute dividend amount per share has fallen sharply to match profitability impact on cash levels and dividend payout ratio.

• Debt repayment: The Company’s debt rose from US$4.9 billion in FY2011 to US$9.6 billion in FY2015. Fortescue Metals Group Limited’s debt remained static at US$9.6 billion in FY2014 and FY 2015. However, the composition of debt structure varied since one type of debt was raised to pay-off another type of debt. The company’s debt declined to US$9.6 billion in FY2014 from US$12.7 billion in FY2013 and affected company’s dividend paying ability. Fortescue Metals Group Limited paid a dividend of 0.22 AUD in FY2014 in comparison to 0.39 AUD in FY2013. Thus, debt repayments affects company’s dividend policy and subsequently results in change in dividend paid by the company to the shareholders. In other words, higher debt repayments would result in lower dividend payout by the company and vice-versa.
• Earnings Stability: The Company considers earnings as the most important factor affecting dividend policy. Higher earnings propel the company to make large dividend payouts and vice-versa. However, the Company gives more weight age to earnings stability in contrast to earnings of any particular year. This is because of the fact that Fortescue Metals Group Limited is engaged in commodity business which is cyclical in nature. Thus, profitability of the company is expected to vary significantly each year and company needs to consider such volatility in net income before announcement of dividends to shareholders (Gordon N A, Anthony Q P, 2011). The company assumes changes in net income based on market conditions and expected future realization on selling of iron ore products. Therefore, the Company tries to neutralize dividend payout ratio in order to match with earnings stability.

• Ownership and Control: The Company is a public limited company listed on the Australian Stock Exchange. Fortescue Metals Group Limited understands that public ownership in the company has emotional and sentimental impact on company’s image in the market place. Thus, the company tries to pay regular dividends to shareholders in order to reward them for their risk and create sustained ownership interest in the company. Moreover, management is of the opinion that regular dividends paid by the company also enable them to build trust and confidence with shareholders. Fortescue Metals Group Limited increases/decreases dividend based upon public ownership in the company. In other words, the company increases dividends in order to induce investors to buy company’s share.

• Access to Capital Market: Finance is the life line of any business. Mining and metal companies require higher amount of capital for funding business expansion. Thus, the company has various sources of alternate finance available to them through access to capital markets. The company can raise money through follow on public offer, right issue and preference shares. Additional equity raising results in dilution of ownership and expansion of capital base. The company needs to consider pre-issue and post-issue equity for dividend payout (Jinhoo K, SooCheong (Shawn) J, 2012). Higher equity base would result in lower absolute dividend paid by the company if dividends are paid on same amount of profits. Thus, access to capital markets for raising additional capital affects company’s dividend policy.

Therefore, it can be concluded that company’s earnings are an important consideration behind dividend payout policies. However, there is no deployment of any particular type of dividend policy by the company. In addition, changes in company’s dividends payouts have largely been affected by company’s current year profitability. It is important to note that other mentioned factors have also affected company’s earnings distribution practices.

Optimal Capital Structure

Fortescue Metals Group Limited’s existing capital structure comprises of debt of US$ 9.569 billion and equity of US$ 7.537 billion. In this section, we compute the optimal capital structure for the company. The company was able to raise debt of US$ 9.569 billion at an average pre-tax debt cost of 3.45%. In our calculation, we assume that company’s credit rating would change if it were to raise debt in excess of US$ 12 billion. This would in turn put incremental pressure on cost of borrowings for the company. The company has different options for raising debt in the form of senior notes and senior secured credit facility. We further assume that the company would be able to raise additional debt at 3.45% pre-tax till US$ 12 billion. Therefore, no matter what form of debt company raises, the cost of debt would equate to 3.45%.

The following table depicts different levels of debt and equity in capital structure. The highlighted portion displays existing mix of debt-equity in the capital structure and proposed alterative capital structure.

The table shows that with every higher level of debt in capital structure, total cost of capital decreases due to increase in weight age of debt (Steven T, 2010). In addition, cost of debt is far lower than cost of equity. Thus, cost of capital is lowest at D/E ratio of 233.33% with debt equating to US$ 11.974 billion and equity amounting to US$ 5.132 billion.

The below diagram shows the relationship between D/E ratio and Cost of Capital:

Thus, change in capital structure has resulted in change in cost of capital. In addition, debt has provided financial leverage to the company. In our case, we observe the following key changes:

By increasing debt weight from current 56.00% to optimal debt weight of 70.00%, there has been a decline in pre-tax cost of capital from 4.25% to 4.00% equating to 0.25% decline in pre-tax cost of capital. Thus, Fortescue Metals Group Limited should raise the debt level by US $ 2.405 billion. The company can use any form of debt instrument provided the pre tax weighted average cost of debt comes at 3.45%. This in turn would result in shoring up debt levels of the company to US $ 11.974 billion and equity composition would stand at US$ 5.132 billion. The new optimal capital structure would have pre tax weighted average cost of capital of 4.00%.

After tax weighted average cost of capital = (3.45%)*(1-0.2674)*0.7 + (0.3)*(5.27%)

= 1.77% + 1.58% = 3.35%.

The above table shows that there has been a decline of 1.57% in after tax cost of capital from current after tax cost of capital of 4.92%. Thus, optimal capital structure for the company stands at debt forming 70% and equity forming 30% of the capital structure.

5. Optimal Capital Budget

Fortescue Metals Group Limited is contemplating four projects and we conduct NPV analysis to see which projects are feasible and should be undertaken by the company. Projects with positive NPV would be undertaken by the company while projects with negative NPV and where information regarding cash inflow has not been provided have been ignored (Joel W, 2014). This is because of the fact that it becomes difficult to assess and ascertain projected cash inflow from the project.

The following table depicts details regarding Capital Project 1:

The below table shows the discount rate applicable for Project 1:

Therefore, Net Present Value of Project 1 = Present Value of Cash Inflows – Present Value of Cash Outflows = $256.91 - $265.00 = - $8.09 million.

Since the Net Present Value of Project 1 is negative, the project is not feasible.

The following table depicts details regarding Capital Project 2:

The below table shows the discount rate applicable for Project 2:

Therefore, Net Present Value of Project 2 is as follows:

Since the Net Present Value of Project 2 is positive, the project would be accepted by Fortescue Metals Group Limited.

The following table depicts details regarding Capital Project 3:

We cannot calculate the NPV of the project since annual cash inflow is not provided. Thus, the company would not consider this project. Therefore, Project 3 would be rejected by the company.

The following table depicts details regarding Capital Project 4:

The below table shows the discount rate applicable for Project 4:

Therefore, Net Present Value of Project 4 = Present Value of Cash Inflows – Present Value of Cash Outflows = $8932.63 million - $4631.72 million = $4300.90 million.

Since the Net Present Value of Project 4 is positive, Fortescue Metals Group Limited would accept the project.

Therefore, the company would accept Project 2 and Project 4.

The following table highlights Capital Budget Requirements for Fortescue Metals Group Limited:

The Company would raise required funds in the ratio of 70% debt and 30% Equity. This is because of the fact that the company has current weight of debt of 56% in capital structure and current weight of equity of 44%. The company’s optimal capital structure would comprise of 70% debt and 30% equity composition. Therefore, Fortescue Metals Group Limited would raise funds in the ratio of 70:30, i.e., 70% debt and 30% Equity.

The below table highlights amount of debt and equity component in raised funds:

The below table depicts Company’s new capital structure:

The below table highlights new weight of debt and equity in the capital structure:

The below table and diagram highlights cost of debt, cost of equity and weighted average cost of Capital for the company for financial year 2016, 2017 and 2018:

The declining weighted average cost of capital would be in line with company’s financial management policies wherein Fortescue Metals Group Limited would put emphasis on raising more debt in comparison to equity for lowering cost of capital. Higher component of debt in capital structure along with lower of debt and tax shield would lower overall cost of capital (Omid S, 2015). In addition, Fortes cue Metals Group Limited would move towards optimal capital structure and fund acceptable projects.