Analyzing Fortescue Metals Group Limiteds Capital Structure And Wacc

The CFO has requested you to submit a Background Analytical Report providing supporting calculation and analysis information. The presentation, prepared employing information from the annual report documentation and any other documentation or sources of information considered relevant, is required to identify and outline the
following aspects of Fortescue Metals Group Limited’s current policy platform and operational activities and performance:

 

The determination of the costs of the various sources of costly or interest-bearing financing employed by the firm and, from this, the firm’s overall weighted average
cost of capital (WACC).

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.

 

The nature of the firm’s earnings distribution policy, including the type of dividend policy employed if relevant, whether the firm has a target dividend policy or payout
ratio, and the influence of taxation or other relevant elements associated with the firm’s overall earnings management and distribution practices.

 

Link to the recent dividend announcement and market share price response to the dividend, discuss the association or relationship between dividend and other various corporate financing policies employed by the firm, and how this may relate to Fortescue Metals Group Limited’s share and/or accounting performance outcomes,
and any other key drivers of the firm’s performance outcomes. 

The below report highlights the capital structure of the firm Fortescue Metals Group Limited. It is one of the leading iron ore production and exploration company which operates in the Pilbara region of northern Western Australia. Based on the last financial years, the capital structure of the firm will be determined and on that basis, several recommendations will be given to the firm.

The cost of capital comprises of overall cost of equity and debts fund of a particular organization.  It is also considered as the required rate of return of the given organizations. Weighted Average Cost of Capital helps in determining the capital structure of the firm (Robb and Robinson 2014)

It can be inferred that all sources of capital, including debt, equity, bonds are included in the calculation of Weighted Average Cost of Capital. The WACC of an organization increases as the rate of return of equity of an organization increases (Zeitun and Tian 2014).  The following tables will reflect the calculation of WACC of the firm Fortescue Metals Group Limited.

Cost of Equity					Amount of Equity
	Riskfree rate		2.39%			Shares		3111
	Beta		0.90			Price		5.22
	Market return		10%			Value		16239.42
	Cost of Equity		9.38%
Cost of Debt					Amount of Debt
	Rate		2.75%			Book value		12257
	Tax rate		30%			Adjustment		1
	Cost of Debt		1.93%			Value		12257
					Total Capital			28496.42
WACC			6.18%

Calculation of WACC for the year 2017

(Source: Created by Author)

Cost of Equity					Amount of Equity
	Riskfree rate		2.88%			Shares		3113
	Beta		0.90			Price		3.5
	Market return		8%			Value		10895.5
	Cost of Equity		7.16%
Cost of Debt					Amount of Debt
	Rate		2.88%			Book value		8992
	Taxrate		30%			Adjustment		1
	Cost of Debt		2.02%			Value		8992
					Total Capital			19887.5
WACC			4.84%

Calculation of WACC for the year 2016

(Source: Created by Author) 

Cost of Equity					Amount of Equity
	Risk free rate		3.42%			Shares		3113
	Beta		0.90			Price		1.91
	Market return		7%			Value		5945.83
	Cost of Equity		6.59%
Cost of Debt					Amount of Debt
	Rate		3.42%			Book value		9813
	Tax rate		30%			Adjustment		1
	Cost of Debt		2.39%			Value		9813
					Total Capital			15758.83
WACC			3.98%

Calculation of WACC for the year 2015

(Source: Created by Author)

Cost of Equity					Amount of Equity
	Riskfree rate		3.45%			Shares		3113
	Beta		0.90			Price		4.35
	Market return		5%			Value		13541.55
	Cost of Equity		4.49%
Cost of Debt					Amount of Debt
	Rate		2.88%			Book value		9981
	Tax rate		30%			Adjustment		1
	Cost of Debt		2.02%			Value		9981
					Total Capital			23522.55
WACC			3.44%

Calculation of WACC for the year 2014

(Source: Created by Author)

From the above analysis, it can be inferred that WACC of the firm has increased over the past few years. This further implies that rate of return on equity of the firm has increased, which can be considered as a positive sign for the firm (Zeitun and Tian 2014).  It also implies that the capital structure of the firm Fortescue Metals Group Limited is less risky and has improved over the years. However, in comparison to industry average, WACC is on the lower side, which can be considered as a negative sign for the firm. In addition to this, it can be also inferred that the share capital of the firm has increased over the years. This can be considered as a positive sign for the firm.

The nature of capital structure of the firm can be evaluated with the help of debt equity ratio of the firm. This ratio measures the percentage of debt over equity of the firm. An ideal debt equity ratio is 2:1 (Peirson et al. 2014).

	2013	2014	2015	2016	2017
Equity	5,702,425,876	8,049,893,842	9,813,802,083	11,319,687,584	12,654,706,188
Debt	13,461,994,609	9,981,953,290	12,257,812,500	8,992,728,252	5,655,226,209
	2.360748724	1.24001055	1.249038079	0.794432548	0.4468872

Table 1: Overview of Debt equity ratio of the firm Fortescue Metals Group

From the above analysis, it can be inferred that the debt equity ratio of the firm has declined over the years. In the year 2017, debt equity ratio of the firm is 0.44. This infers that 44 percent of the total capital is financed by debt and the rest 66 percent is financed by equity. This infers that firm is exposed to less amount of risk in 2017 in comparison to previous years. There are several determinants of capital structure of the firm (Albul, Jaffee and Tchistyi 2015). These are:-

• Tax exposure-The organization is exposed to tax exposure, therefore, it is important for the firm to minimize the debt in comparison with the previous years.
• Financial flexibility– It has been seen that the primary objective of the firm to attain 155million tones production. Therefore, it is important for the firm to be financially stable. Therefore, the debt portion of the firm has declined to make the capital structure risk free.
• Growth Rate- It is important for the firm to improve the growth rate and its cost of capital and return on equity. Due to this reason, more portion has been kept for equity and less of debt.

From the above analysis, it can be deduced that the above factors play an important role in the determining the capital structure of the firm. In addition to this, it has been also seen that the percentage of Total liabilities to shareholders’ equity of the firm has declined. This can also be considered as a positive sign for the firm.

From the above analysis, it can be inferred that the WACC of the firm has increased over the years. This reflects the percentage of ownership capital has also increased and financial leverage of the firm Fortescue Metals Group has declined considerably. In addition to this, the debt equity ratio of the organization has declined which provides further financial flexibility to the organization.

Albul, B., Jaffee, D.M. and Tchistyi, A., 2015. Contingent convertible bonds and capital structure decisions.

Peirson, G., Brown, R., Easton, S. and Howard, P., 2014. Business finance. McGraw-Hill Education Australia.

Robb, A.M. and Robinson, D.T., 2014. The capital structure decisions of new firms. The Review of Financial Studies, 27(1), pp.153-179.

Zeitun, R. and Tian, G., 2014. Capital structure and corporate performance: evidence from Jordan.