Southport Minerals Anirban

Southport Minerals, Inc. Finance II, Assignment - 1

Submitted By: Anirban Chakraborty, Section – B, Roll -2010PGP043 2/18/2011

Introduction:Southport Minerals, Inc. is the largest U.S. sulphur producer had been enjoying sharply increasing profitability after five years of low profitability. So they were financially well positioned for significant diversification and had high liquidity in the system with no debt in their capital structure. So they were in the hunt for attractive investment opportunities. In 1967, Southport Minerals found an opportunity for a major financial commitment to develop a copper mine in Indonesia. The major body of the copper ore was at an extremely inaccessible location in the Firstburg, Indonesia. Southport Indonesia (SI), a wholly-owned subsidiary of Southport Minerals, entrusted with a responsibility of mining. While contemplating to invest in the copper mine Southwest Minerals tentatively negotiated a complex financing package for the project. While assessing the new investment plan Southport Minerals, Inc came up with 4 different methods for analyzing the investment worth of the project:  Discount at Southport Minerals’ cost of capital, ignore the specifics of the financing choice  Discount at a premium above Southport Minerals’ cost of capital; ignore the specifics of the financing choice  Discount at Southport Minerals’ cost of capital, thereby taking into consideration the specific financing choice  Discount the dividends paid versus the equity invested at SI’s cost of equity

Investment Structure:In total the project required $120million investment. They wanted to have a debt-equity ratio of 83% in their capital structure. Following are the important points in the proposed investment project:  Japanese consortium agreed to lend SI $20 million in subordinate debt at an interest rate equal to 7 %.the loan would be repayable at a rate of $3.3 million per year between 1975 and 1980. The Export Import Bank of Japan guaranteed the repayment of this loan  German Bank would lend SI $ 22 million of senior debt at 7% interest. This loan was repayable between 1974 and 1982 in escalating instalments, and it guaranteed by the Federal Republic of Germany  A group of US Banks agreed to advance $18 million repayable between 1974 and 1976 at a interest of 7% , repayment of this debt was guaranteed by an agency of the US government  A group of US Insurance companies agreed to lend SI $40 million repayable between 1975 and 1982 at an interest of 11%, this debt was guaranteed by the Overseas Private Investment Corp, an agency of the US government  Southport Minerals Inc was to invest $20 million of equity capital into SI for the project Now the expropriation risk is shifted to three Governments rather than one. The loans became Government-guaranteed loans effectively. These 3 countries are major trading partners of Indonesia.

The benefits of above contract-structuring program to SM are $27 mil. The value of equity can be measured using the APV technique. PV (equity) of 8.64 + PV(ITS) of 11.34 = $19.98 as value of project.

Analyze the Financial plans:Approach1: Approach 1 ignores the clever financing architecture of SI and the fact that cash flows to Southport can only happen if SI prepays that same amount in debt. The relevant cash flows in this model are flawed because it takes into account cash flows made at Southport Indonesia and not Southport Minerals, the cash flows remaining in Indonesia create no value for Southport Minerals and really shouldn’t be used in assessing the project. Approach2: Approach 2 uses the same logic as 1 except hikes the discount rate up to 20% to add some risk to the picture. It may be true that the WACC in most years is 20% due to the capital structure being all equity, however it doesn’t take into consideration the clever debt arrangements and the dividends paid to Southport Minerals. Approach3: Approach 3 is better than 1 and 2, as it does take into consideration Southport Indonesia’s clever financing structure. However, for the majority of the years the project will be 100% equity using the dividend cash flow statement. This will raise the WACC as the later years of the project will use no debt and be all equity, the WACC will be too low if 7.6% is used to discount all cash flows. Having three different countries invest money into the project protected SI against expropriation against the Indonesian government. If they had expropriated them they would have caused several disruptions in their investments and possible legal and economic penalties would have resulted. This clever financing made the riskiness of this venture much lower had Southport only gone with U.S. investments as they successfully diversified its capital investment across three different nations. The loans by foreign governments also carry a lower interest rate than the U.S. loans, so this in itself will make the return on equity invested much higher had Southport gone with all U.S. financing. The $40 million insurance company loan is costing them 11% pre-tax, compared to 7% interest on Japanese debt, and 7% on German debt. Conclusion: The project should be accepted as using approach 4 the NPV of price of copper of 40 cents a pound and a cost of capital of 20% will be around $10 million. Average WACC considering every year of the project is around 14.1888%. Therefore the project should be accepted.