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Question:

i)Using information from the latest company report for the company (i.e. interest rate on their major source of long-term loans) and the estimated cost of equity capital calculated (in part 6ii above), calculate the WACC for your company.

  1. ii) Explain the implications that a higher WACC has on management’s evaluation on prospective investment projects.

Consider the debt ratio for your company over the past two years:

  1. i) Does it appear to be working towards the maintenance of a preferred optimal capital structure? (i.e., does it appear to be “stable”?). Explain your answer.

What have they done to adjust/amend their gearing ratio? Increase or repay borrowings? Issue or buy back shares? Has the Director’s Report given any information as to why they have made any adjustments?

Dividend policy

Discuss what dividend policy of the management of the company appears to be implemented. Explain any reason related to that particular dividend policy.

Based on your analysis above, write a letter of recommendation to your client, providing an explanation as why you would like to include this company in his/her investment portfolio. Please refer to the ratio results calculated earlier and any other trends or factors that you believe to be important.

 

Answer:

Description of the company

Mount Ridley Mines Ltd is the exploration company that is primarily focussed on the projects in region of Fraser range. The company is based in Perth, Australia. It has the potential of hosting the major deposits for minerals and various precious metals like copper, nickel, lead, cobalt, lead gold, silver and zinc. The entity is managed by the team of significant expertise and motivated professionals in the field of mineral exploration corporate and finance management and mining operations with the proven track record for successfully delivering the value to the shareholders (Mtridleymines.com.au 2018).  

Specification of ownership structure

  1. Major substantial shareholders
  • More than 20% shareholding – there are no substantial shareholder holding more than 20% shares
  • More than 5% holding of shares – Mount Street Inv Pl < M J Blake S/F A/C > is holding 90,000,000 of total shares that is equal to 8.50% shares.
  1. Name of main people
  • Chairman – Michael Pedley
  • Board members
  • Guy Le Page – Non-executive Director
  • Ashley Hood – Managing Director
  • Keith Bowker – Non-Executive Director
  • CEO – Michael Pedley

Key ratios of Mount Ridley Mines Limited

  1. Return on assets (ROA) = (NPAT / Total Assets)

Return on Equity (ROE) = (Net profit after tax / Ordinary equity)

Debt ratio = Total liabilities / Total assets

EBIT/TA * NPAT/EBIT * TA/OE = NPAT/OE

EBIT/TA * NPAT/EBIT * TA/OE = -29,73,573/19,95,883 * -20,68,511/-29,73,573 * 19,95,885 /18,15,193 = -1.14

NPAT/OE = -20,68,511 / 18,15,193 = -1.14

Hence, it is proved that –

EBIT/TA * NPAT/EBIT * TA/OE = NPAT/OE

  1. Phenomenon of TA/OE

TA/OE or the total asset against owner’s equity represents the company’s insolvency risk and the percentage of total asset held by the shareholders. If the total asset to owner’s equity ratio is high then the sustainability risk of the company will go high as higher debt will increase the interest risk. On the other hand, if the TA/OE ratio is lower it will represent that the debt portion is low and the company will be considered as strong for long-term sustainability (Chandra 2017).

  • Reasons why ROE being higher than ROA

ROE becomes more than ROA when the debt of the company goes up, the equity part of the capital structure goes down. Since, ROE is the NPAT as compared to the equity, reduction of equity increases the ratio. Further, if the debt can be raised at lower cost as compared to the ROA, the company actually makes money from its debt and it will result into increasing of ROE (Guerard 2013). Hence, when the ROE is higher as compared to ROA, it will be considered that the interest rate is lower than the ROA.

 

Information from ASX website

  1. Monthly stock movement – 2 years time period

Stock movement graph

  1. Report on stock movement

It can be analysed from the above graphs for stock movement that the stock of Mount Ridley Mines Limited has no specific trend and it is continuously fluctuated over the last 2 years.  Therefore, the stock will be considered as volatile (Albul, Jaffee and Tchistyi 2015).  On the contrary, the stock of All Ordinary Index is stable and moving upward slowly. Further, the both have negative correlation among them as the correlation came as -0.142.

Recent announcement

  • Mathew James Blake, the substantial shareholder of the company changed its holding from 91,850,000 shares to 91,850,000 shares. It changed their voting power from 7.55% to 6.04%.
  • The company completed the Audio Magnetotelluric geophysical survey at their fully owned project of Mount Ridley under the Albany-Fraser range province. Thesurvey was planned for immediately covering the T19C01 and existing holes for mineralised diamond.
  • The company has been granted the ASX trading halt with regard to the programme for maiden drilling at their Mt. Ridley project.

Stock field 

  1. Calculated beta of Mount Ridley Minerals Ltd is 3.59
  2. Risk free rate = Rf= 4%, Market risk premium = Rm = 6%

Therefore, required rate of return of the company’s share =

R = Rf  + β ( Rm – Rf )

R = 4% + 3.59* (6% – 4%) = 4% + 7.18% = 11.18%

  • Conservative investment

The conservative investment if properly applied it will be a low risk and low return associated investment. Risk factor is the quantity of risk the investor is ready to take at the time of investment. The risk profile of any investor can be aggressive, moderately aggressive, conservative or moderate. The conservative investors are those who are risk averse. Such kind of investors highly prefers the safety related to the investment and is satisfied with the normal returns (Frank and Keith 2016). From the above, it is identified that the beta risk of the company is 3.59 which is considered to be significantly high. Further, as the net income of the company is in negative form, it could not earn any positive return. Therefore, the stock will not be considered as conservative investment.

WACC (weighted average cost of capital)

  1. Computation of WACC

WACC = E/V * Re +D/V * Rd * (1-Tc), Where,

E/V = Equity percentage in the capital structure

D/V = Debt percentage in the capital structure

Re = Cost of equity

Rd = Rate of debt

Tc = corporate tax rate

However, it is recognized that the company has no borrowing or debt for the year. Therefore, the entire capital structure of the company includes the equity component only. Hence, the the weighted average cost of capital will be cost of equity that is 11.18%.

  1. Implication that the higher WACC has on the evaluation of management

High level of WACC is the signal for higher risk association with the operation of the firm. The investors will require the additional return for assuming the additional risk. the value investors may also become concerned regarding whether the WACC is more than the actual return (DeFusco et al. 2015). It includes the payments for debt obligation or cost associated with debt financing and required return rate asked by the ownership or by the cost required for equity financing.

Optimal debt structure

  1. Optimal structure for capital

Debt ratio

Total liabilities / Total assets

Year 2016 = 0.091

Year 2015 = 0.131

Optimal capital structure is the percentage of debt and equity component in the capital structure at which it can maximise the value of the company. The debt ratio of 40% or lower than 40% is considered ideal for the company; However, if the last two year’s debt ratio for Mount Ridley Minerals Limited is taken into consideration, it can be found out that the debt ratio for 2015 was 13.10% and for 2016 is 9.10% which is very low. Hence, for additional fund requirement it can rely on debt instead of equity (Renneboog and Szilagyi 2015).

  1. Gearing ratio

It is found from the annual report of the company that for adjusting the gearing ratio the company increased their equity amount from $ 19,201,817 to $ 21,017,352 over the years from 2015 to 2016. Though the director’s report did not mention anything regarding this, it is disclosed through notes to accounts that the owing to the company’s activity’s nature id does not have immediate access to the credit facilities (Heikal, Khaddafi and Ummah 2014). Therefore, the primary source of fund for the company is equity.

Dividend policy

The company did not declare or pay any dividend during the accounting year. Further, it did not recommend for divided payment. The reason for this policy is that the company was not able to earn positive earning over the last 4 years. Therefore, they do not have sufficient amount to pay the dividend (Akeem et al. 2014).

Recommendation 

It is recommended from the above analysis that the company’s stock shall not be included in his portfolio as the risk that is beta of the stock is 3.59. Further, over the last 4 years the company could not earn any positive earning. Therefore, with regard to the return aspect as well as the risk aspect, the stock of the company is not feasible for investment and shall not be included in the portfolio.

 

Reference 

Akeem, L.B., Terer, E.K., Kiyanjui, M.W. and Kayode, A.M., 2014. Effects of capital structure on firm’s performance: Empirical study of manufacturing companies in Nigeria. Journal of Finance and Investment Analysis, 3(4), pp.39-57.

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

Chandra, P., 2017. Investment analysis and portfolio management. McGraw-Hill Education.

DeFusco, R.A., McLeavey, D.W., Pinto, J.E., Anson, M.J. and Runkle, D.E., 2015. Quantitative investment analysis. John Wiley & Sons.

Frank, K.R. and Keith, C.B., 2016. Investment analysis and portfolio management.

Guerard Jr, J.B., 2013. Introduction to financial forecasting in investment analysis. Springer Science & Business Media.

Heikal, M., Khaddafi, M. and Ummah, A., 2014. Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia stock exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), p.101.

Mtridleymines.com.au., 2018. Mount Ridley Mines - Home. [online] Available at: https://www.mtridleymines.com.au/ [Accessed 29 Jan. 2018].

Renneboog, L. and Szilagyi, P.G., 2015. How relevant is dividend policy under low shareholder protection?. Journal of International Financial Markets, Institutions and Money

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