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9-913-548
REV: OCTOBER 11, 2013
WILLIAM E. FRUHAN
WEI WANG
New Earth Mining, Inc.
Company Background
It was the beginning of 2013. After gold prices experienced an unprecedented boom from $300 per
ounce to $1,700 per ounce in the previous decade, Denver-based New Earth Mining, one of the
largest U.S. precious-metal producers, was enjoying rapid growth in earnings. With the continued
improvement of its operating margins, New Earth had accumulated a large amount of cash on its
balance sheet (Exhibit 1). It had a simple debt structure and a reasonable leverage ratio with no
significant risk of liquidity.
Most of the company’s mines were located in the U.S. and Canada, but like many other firms in
the precious-metals industry, New Earth had made substantial investments in gold exploration
projects in other countries such as Australia and Chile. However, like many industry participants,
New Earth executives worried about the sustainability of gold prices at their current levels. With its
strong financial condition and the desire to diversify its business through new capital investments
rather than acquisition, New Earth felt it was necessary to implement a diversification program that
would reduce its dependence on precious metals. The company started investigating the possibility
of diversification in base metals and other minerals.
New Investment Opportunity in South Africa
A new investment opportunity appeared in early 2012. New Earth was informed of the existence
of a major body of iron ore close to the massive Kalahari manganese field in the Northern Cape of
South Africa by an independent exploration consulting company. New Earth felt an investment in
iron ore provided a strategic fit for its diversification objective.
Since steel represented almost 95% of the metal that was used in the world, iron ore was arguably
more integral to the global economy than any other mineral. The price of iron appreciated more than
five-fold from 2002 to 2012 (see Exhibit 2). Unlike the price of gold, for which there was considerable
________________________________________________________________________________________________________________
HBS Professor William E. Fruhan and Professor Wei Wang, Queens University, Kingston, Ontario, prepared this case solely as a basis for class
discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. Although based on
real events and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entities is
coincidental.
Copyright © 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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913-548 | New Earth Mining, Inc.
speculation, the price of iron ore was not expected to fall dramatically given the strong global
demand for the commodity. According to a 2012 report by the U.S. Geological Survey, the world iron
ore market would continue to be tight, with demand exceeding supply until at least 2016. This was
due to the long lead times required to bring mines into production, a world shortage of skilled labor,
and growing natural resource nationalism, which reduced exports from some nations. Given that the
price of iron ore had appreciated dramatically after 2007 and was expected to stay above $80 per
metric ton, New Earth decided to evaluate the feasibility and profitability of developing the Kalahari
mine.
New Earth hired Drexel Corporation, an engineering and construction firm, to analyze the extent
of the deposit and to determine the cost and feasibility of establishing a mine site close to Kalahari.
The engineering firm found that the field contained 30 million tons of ore with an average iron
content of 60%. At the projected extraction rate of 2 million tons per year, it would take 15 years to
deplete the ore body.
Drawing in part on its earlier evaluation of an iron ore project in Sishen, South Africa, Drexel
estimated in October 2012 that the proposed venture in South Africa could be operational by the
beginning of 2015. Drexel reported that there was limited need for infrastructure investment to
support the development of the mine, and the total investment cost was estimated to be $200 million
with 40% of the investment required at the beginning of 2013 and the rest required at the beginning
of 2014. This investment amount would include construction costs and related insurance, operational
costs, and $20 million in working capital. Ore would be trucked to Durban and railed to Port
Elizabeth in the Eastern Cape for export. Given the high quantity of iron contained in ore mines in
South Africa and the easy access to ports from the mine location, the venture was expected to have
low production costs.
By November 2012, New Earth was able to produce pro forma analysis on the profitability of this
new investment (Exhibit 3). The analysis revealed that the investment opportunity had attractive
potential. At an assumed price of $80 per ton, the investment opportunity promised strong cash
flows. The project would produce even stronger cash flows given an optimistic price forecast of iron
ore at $100 per ton. New Earth also performed a sensitivity analysis to analyze the impact of various
discount rates and iron ore prices on the net present value of the project’s cash flows (Exhibit 4).
Despite its initial attractiveness, the project carried some substantial risks that New Earth needed to
consider.
Market for Iron Ore
Iron ore was consumed predominantly by the steel industry. China, Japan, and South Korea were
among the top countries in both iron ore imports and steel production (Exhibit 5). In 2010, China
imported almost 60% of the world’s total iron ore exports. Japan and Korea were next among the top
importers. During the previous decade, world seaborne demand in iron ore had doubled since 2000.
According to BHP Billiton, one of the world’s largest iron ore producers, global seaborne iron ore
trade was expected to grow steadily over the next decade, at an annualized rate of 4.4% per year.
Also, according to AME Mineral Economics, an independent research house on commodities, crude
steel production in these three Asian countries was expected to grow more than 35% in the next
decade.
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New Earth Mining, Inc. | 913-548
South Africa
According to the U.S. Geological Survey, as of the beginning of 2012, South Africa was ranked
14th in the world in iron ore reserves, with an estimated one billion tons of crude ore. Additionally,
South Africa was ranked as the 7th largest producer of iron ore in the world (Exhibit 5). Most of the
country’s reserves were located in the Northern Cape Province in the large Kalahari manganese field,
close to the Botswana and Zimbabwe borders. Saldanha Bay was one of the primary ports used to
export iron ore, with more than 34 million tons passing through it each year. Because South Africa
was positioned to be one of the major exporters to Asia, significant construction efforts had been put
into building new ports and facilities for ore exports.
New Earth was worried about a number of risk factors associated with making a large investment
in South Africa. The political system was unstable and corruption was a major ongoing concern.
Industry experts ranked it as one of the top countries in terms of political risk affecting mining
operations. High risk of civil war in neighboring countries was a constant threat. Furthermore, there
existed the ongoing fear with all less-developed countries such as South Africa that the government
would nationalize natural resource operations.
Fortunately for New Earth, multiple countries including China, Japan, and South Korea were
extremely supportive of the assurance of long-term supply of raw materials to their domestic steel
producers as steel production was vital to their economic growth. Their governments had provided
various forms of credit guarantees to mining operations in a number of less-developed countries.
These guarantee programs made it possible for New Earth to protect itself against the significant
political risk embedded in the South African venture.
Negotiating a Financing Package
By December 2012, New Earth had tentatively secured a few large steel producers located in
China, Japan, and South Korea as major customers. Iron ore would be shipped to these countries via
seaborne trade. The two steel producers in China were contractually obligated to purchase half of
New Earth’s Kalahari iron ore output while those in South Korea and Japan were contractually
obligated to purchase the other half. The purchase would be settled at the ore market price at the time
of the ore shipment. New Earth would form a new subsidiary, New Earth South Africa (NESA), to
undertake the mining operation. It had tentatively negotiated a financing package with the potential
customers and a syndicate of U.S. banks for its South African venture.
Of the $200 million needed to complete the project, $100 million was tentatively negotiated with
the overseas buyers. The two steel makers in China agreed to lend NESA $60 million in senior
subordinated debt at 9% interest. This loan would be repayable at the rate of $8 million per year
between 2022 and 2028, with the final $4 million paid down in 2029. The loan was guaranteed by the
People’s Republic of China. A comparable financing agreement was arranged with the group of steel
makers in South Korea and Japan. To induce NESA to sell half of the iron ore output to the
companies based in these two countries, a large Japanese bank and Export–Import Bank of South
Korea agreed to jointly provide $40 million senior unsecured debt at an interest rate of 7%. This loan
was payable between 2016 and 2026 at a decelerating rate (Exhibit 6), and was guaranteed by the
central banks in these two countries.
New Earth turned to domestic lenders to obtain the remaining financing necessary for the South
African investment. A group of U.S. banks tentatively agreed to provide a syndicated bank loan
worth $60 million, repayable between 2016 and 2023 to NESA. The senior bank loan would carry a
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913-548 | New Earth Mining, Inc.
10% interest rate and be collateralized by the mining equipment, which would be purchased from a
large U.S. manufacturer. An export facilitating arm of the U.S. government agreed to guarantee this
loan. In total, $40 million worth of loans were to be provided at the beginning of 2013 and $120
million worth of loans were to be provided at the beginning of 2014. Repayments were to be made
starting at the end of 2016 (Exhibit 6). In addition, no interest was to be paid in 2013 and 2014. The
interests accrued in those years would be payable at the end of 2015 with no interests compounding.
Various loan covenants were embedded in the financing package. After deducting interest and
contractual debt repayments, NESA would use all remaining discretionary cash flow for
prepayments of debt and the issuance of dividends. The amount paid out in dividends was not to
exceed the amount allocated to prepayment of debt. Both senior secured and unsecured debt was to
be paid in full before junior debt, according to the debt prepayment schedule. The actual amount of
prepayment to each class of senior debt was proportional to the original principal amount. Finally, no
dividends could be paid to New Earth until December 31, 2016.
To complete the investment, New Earth would invest the remaining $40 million in NESA as
equity capital, at the beginning of 2013 (Exhibit 7). The National Assurance Corp, an insurance
company backed by the U.S. government, guaranteed New Earth’s investment in South Africa
against potential losses due to civil war and government nationalizing natural resource assets. To
further protect its investment, New Earth struck a deal with all its financing parties. It was agreed
upon with each party of the proposed $160 million debt financing that in the event of a cost overrun,
the amount of capital supplied would automatically increase by up to 25% on a pro rata basis for all
lenders. Hence, the project would be guaranteed for $240 million investment before New Earth
would have to resort to additional funding. The mining operation would be carried out solely by
NESA, the new subsidiary, which would further protect New Earth against potential liabilities. New
Earth would not have to guarantee nor be responsible for NESA’s debt obligations.
Project Valuation
The tentative financing package arranged by New Earth had the potential to turn an otherwise
unattractive project into a profitable investment opportunity. However, the complex financing plans
created some challenges for New Earth in evaluating the investment worth of the new project. Four
different valuation approaches were proposed. Each valuation approach had a different champion.
These included the vice president of operations, the accounting officer, an outside consulting firm,
and a financial analyst within the firm. The CFO of New Earth was considering all available
approaches to determine the correct valuation of their South African venture.
Approach 1 – VP of Operations
The VP of operations called for discounting the projected cash flows to be generated at NESA by
New Earth’s 14% weighted average cost of capital, which is obtained as the weighted average of the
cost of equity (15%) and the cost of debt (10%) with leverage assumed to be at 12% of the capital
structure. All specifics on financing of NESA were ignored. Given the projected price of iron ore
at $80 per ton, he suggested that the net present value of the investment project was $83 million
(Exhibit 4).
Approach 2 – Accounting Officer
The accounting officer at New Earth suggested that the new investment in South Africa carried
substantially higher risks than the typical investments that had been made by the company in the
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New Earth Mining, Inc. | 913-548
past. He also argued that since New Earth’s major operation had been gold exploration and
production it would be inappropriate to use the company’s cost of capital for the new venture. Based
on similar investments that were made by peer companies in iron ore development in developing
countries the accounting officer proposed to discount the projected cash flows at 24%, a 10%
premium above New Earth’s cost of capital. The specifics of the financing package were ignored.
Given the new discount rate the project would have a net present value of -$28 million (Exhibit 4).
Approach 3 – External Consulting Firm
New Earth hired an outside consulting firm to provide an independent perspective on the
profitability of the new investment. The consulting firm suggested that the NESA investment was a
stand-alone project for the company with unique opportunities and leverage properties. On the one
hand, the required rate of return on the company’s equity investment in NESA would be higher than
the company’s own 14% cost of capital because the new investment carried considerable risks. On the
other hand, the substantial leverage taken by New Earth for the new venture could result in lower
cost of capital for the subsidiary than the parent company. Therefore, the cost of capital for NESA
should be properly estimated and all cash flows from the project would be discounted at this rate.
The cost of NESA’s equity was assumed to be 24% given the risks and substantial leverage associated
with the project.
Approach 4 – Internal Analyst
A financial analyst working at New Earth suggested that the company compare the discounted
cash flows for equity holders at NESA’s cost of equity (24%) to the equity invested by New Earth,
known as the Flows to Equity approach. The rationale behind this approach was that New Earth’s
relevant investment was $40 million and the cash flows consisted of only the dividends to be paid to
equity holders. New Earth would be completely insulated from the threat of losing more than its
equity invested in NESA. Based on this approach, a full partitioning of the projected cash flows to
debt holders and equity holders had to be estimated. The analyst created the cash flow partition to
different providers of capital (Exhibit 7) as well as the schedule of debt amortization with debt
prepayment (Exhibit 8). His analysis included a faster retirement of debt principal due to the
prepayment covenant.
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800-988-0886 for additional copies.
142
674
1,817
1,058
3,549
71
479
647
897
2,023
1,288
238
1,526
1,321
885
436
222
98
17.32
185
3,205
2.1
0.53
0.18
33
Short-Term Borrowing and Current portion of Long-Term Debt
Total Current Liabilities
Long-Term Debt
Other Liabilities
Total Liabilities
Total Common Stock
Minority Interest
Total Equity
Earnings and Market Valuation
Revenue
COGS
Gross Profit
Operating Income
Net Income
Share Price
Number of Common Shares Outstanding
Market Value of Common Equity
Market Value of Equity/Book Value of Equity
Earnings/Share
Dividends/Share
Price/Earnings Ratio
2002
1,852
1,185
667
320
168
30.12
223
6,716
2.5
0.75
0.18
40
52
591
654
866
2,111
2,522
164
2,686
197
820
2,303
1,674
4,797
2003
2,456
1,302
1,154
575
332
39.82
230
9,159
2.3
1.44
0.35
28
110
789
610
1,041
2,441
3,807
175
3,982
552
1,214
2,466
2,743
6,423
2004
2,879
1,468
1,411
863
512
57.75
244
14,091
2.6
2.10
0.45
28
165
1,027
788
1,103
2,918
4,937
482
5,420
759
1,684
3,052
3,602
8,338
2005
Key Financial and Market Value Data, 2002-2011 (in millions of dollars except for ratios)
Balance Sheet
Cash and Marketable Securities
Total Current Assets
Net PP&E
Other Assets
Total Assets
Exhibit 1
2,966
1,554
1,412
906
489
55.22
256
14,135
2.0
1.91
0.45
29
151
1,441
1,257
2,213
4,911
6,368
700
7,068
1,138
2,288
4,804
4,887
11,979
2006
4,851
2,421
2,430
1,696
982
64.24
278
17,858
2.5
3.53
0.70
18
153
1,517
1,666
1,990
5,173
6,400
743
7,143
1,121
2,168
7,648
2,500
12,316
2007
5,322
2,725
2,597
1,426
812
57.23
298
17,055
2.3
2.72
0.70
21
79
1,512
1,757
2,454
5,723
6,184
1,100
7,284
1,351
2,016
7,661
3,330
13,007
2008
6,218
2,761
3,457
2,036
1,150
55.98
322
18,026
2.0
3.57
0.90
16
75
2,332
2,355
2,023
6,710
7,489
1,405
8,895
1,888
3,480
7,818
4,307
15,605
2009
7,864
3,672
4,192
2,750
1,635
63.18
340
21,481
2.0 …
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