Southport Minerals - Analyzing the Proposed Financing Programs

Executive Summary

Southport Minerals, being in a highly liquid position, sought diversification to lessen its dependence on sulfur. They found establishing new operations around the copper mind in Firstburg to be an attractive potential investment. Based on a variety of analysis performed, we recommend Southport focus on a couple key actions to better position the company as they take on the Firstburg opportunity.

Recommendations

• Use Approach 4 to estimate the net present value of the Firstburg project

• Concentrate on negotiating more favorable contract terms in allowable dividends

• Move ahead with this venture; scenarios using both conservative top line prices and conservative discount rates show positive NPV

Analyzing the Proposed Financing Programs

The first approach doesn’t recognize that cash flows to Southport only happen if Southport Indonesia prepays that same amount in debt. This is a flaw because Southport only receives cash equal to the amount of the allowable dividend by Southport Indonesia (SI). The second approach uses the same logic as the first except that it increases the discount rate to 20% to add a risk premium due to the nature of the investment. The WACC in the later years could be 20% due to the capital structure being all equity as debt is paid off, however again this approach doesn’t take into consideration the loan covenant and restrictions on allowable dividends. The third approach also does not take into account the appropriate cash flows, and therefore should not be used. The fourth approach is the most reasonable as the actual investment of Southport is only $20M, not $120M. By setting up SI, Southport is not responsible for the SI’s debt obligation. The only cash that Southport invests is their equity, which has a cost of capital of 20%, including an appropriate risk premium. The only cash that Southport receives are the dividend payments from SI after debt obligations. The other approaches in discounting the project don’t take into account only the cash flows that Southport distributes or receives.

Risk & Return

Both Southport’s risk and return potential are decreased due to the financing structure of the Firstburg project. Because of the high risks of expropriation in Indonesia and potential risk for fluctuation in copper prices, this project carries substantial risk. However, the structure of this investment makes SI responsible for the brunt of the risk. The mitigated return potential on the Firstburg project is a function of the required debt repayment. During the early years of the project, debt service consumes most of the expected cash flow. Debt repayments depend 100% on the project’s ability to generate cash because