The Capital Structure Decision Of New Firm Essay

Question:

Discuss about The capital structure decision of new firm.

Answer:

Description of company:

Metallic Minerals Limited is a bauxite developer of Australia that has assets based in Cape York Peninsula of Queensland. Currently, company is concentrating on development and production of its bauxite assets and is transitioning from exploration of minerals. It would help organization in fulfilling the goal of becoming a sustainable, successful and profitable bauxite mine producer. Opportunities to unlock the value from noncore assets are being investigated by company that will help in generating revenue and increase production efficiency. Some of the operations that are owned by company involve Urquhart bauxite project, HMS exploration, Cape York regional bauxite and Urquhart point HMS project (metallicaminerals.com.au, 2018). It has been indicated by Urquhart bauxite project that there will be potential for delivering strong financial returns with minimum capital expenditure. Organization has received approval from Commonwealth and Queensland government for mining lease. It is also seeking approval from government regarding haul road. Cash reserves of company have been bolstered by availability of standby credit facility, conversion of options and completion of right issue (metallicaminerals.com.au, 2018).

Ownership and governance structure of company:

The board of directors of metallic minerals comprised of two non-executive directors, non-executive chairman and alternate non executive director. There are no substantial shareholders having higher than 20% of shareholders and the shareholder having higher than 5% of shareholdings is Jien mining Pty limited. It can be seen that there are no shareholders having more than 20% of shares and hence it can be concluded that company is a non-family company.

Main people involved in governance firms are non-executive chairman, non executive director and alternate non executive director.

Chairman of metallic minerals is Mr, Wang ruobing and he is the largest shareholder of company through its Australian subsidiary. CEO of company is Steve Boulton that has experience in this position over past fifteen years. Other board members include Peter Turnbull who is the non-executive director of company and he has enabled development of business on a global perspective and has considerable experience in commercialization and digital economy. John Haley is the chief financial officer and company secretary and Simon Slesarewich is chief executive officer (metallicaminerals.com.au, 2018). It can be seen that surname of substantial shareholders do not have same surname as that of any members of board of directors. Yes, one shareholder having highest number of shares is involved in the governance of metallic minerals.

Calculation of performance ratios:

The performance of metallic minerals has been evaluated by computation of key performance ratios such as return on assets, debt ratio and return on equity. Return on assets for company for four consecutive years is negative. Value is computed at -90.57% in year 2014 and this has increased to 108.95% in year 2015 and -48.5% in year 2016 respectively. This negative value is indicative of the fact that assets are not utilized profitably for generating revenue.

Return on equity for metallic minerals in year 2014 and 2015 stood at -95.10% and -86.81% respectively. This value has increased significantly in year -117.45% in year 2016 and has reduced to -43.92% in year 2017. There has been improvement in return generated from equity in sense of increasing utilization of shareholder equity. However, value of return generated on equity has been negative and it is indicative of the fact that equity of organization has not been utilized efficiently for generating return to shareholders (Omar et al., 2014).

Looking at the value of debt equity, it can be seen that debt ratio has increased significantly from 0.048 in year 2014 to 0.053 in year 2015 and 0.072 in year 2017 respectively. Increase in value of debt ratio is illustrative of the fact that proportion of debt in relation of total equity has increased. However, in the financial year 2017, debt ratio stood at 0.050 and this fall in ratio depicts that company is paying off its debt or they are not able to acquire any other debt in their capital structure.

Particulars`

2014

2015

2016

2017

Net Profit after Tax (NPAT)

A

-15333124

-7722353

-5747331

-2559121

Total Assets (TA)

B

16930337

9395752

5275212

6087641

Ordinary Equity (OE)

C

16122365

8895597

4893573

5826342

Total Liabilities

D

807972

500155

381639

261299

Return on Assets (ROA)

E= A/B

-90.57%

-82.19%

-108.95%

-48.51%

Return on Equity (ROE)

F=A/C

-95.10%

-86.81%

-117.45%

-43.92%

Debt Ratio

G=D/B

0.048

0.053

0.072

0.050

TA/OE is the total assets divided by total equity and the relationship between return on assets and return on equity is considerably impacted by it. ROE depicts that how well company is utilizing their equity for generating revenue. An increase in value of total assets is likely to increase the value of return generated on assets and would decrease value of return on equity provided there is an increase in profit generated by company (Renneboog & Szilagyi, 2015). If the company generates negative profits, then the impact on ROA and ROE would be negative.

ROA is greater than ROE because the value of total assets is more than value of ordinary equities. Throughout the years of analysis, value of assets has exceeded value of equities; however, their individual value has been declining.

Graph with the description of results:

From the above graph, it can be seen that there is wide fluctuations in the prices of shares of metallic minerals in the beginning of year 2017. In the year 2015 and until end 2016, the movement of share price index has been in line with All ordinaries index. All ordinaries index have been fluctuating and the graph depicts that line is sometimes above price of shares of metallic minerals and for few months, ordinaries index price is below the share price. In the later parts of years, there have been wide fluctuations in the price of shares of metallic minerals. In the recent year, price of shares is below ordinaries index (Armenter & Hnatkovska, 2017). Therefore, in recent years, there has been much wider volatility in share price and in the beginning year, share price line is closely related.

Significant factors influencing the share price of Metallic Minerals:

Share price of Metallic minerals is influenced by the announcement made by company regarding grant of mining lease by the State government. Development of Urquhart bauxite has been done by imposition of development and conditions. The appointment of haulage and mining contractors are done in the project of bauxite and the project is fully funded. Some of the projects is being evaluated by company for the acquisition purpose. Australian mine shares are expected to be granted to metallic minerals on the completion of definitive feasibility study is also likely to influence share price (Faccio & Xu, 2015). Therefore, the share price of organization has the likelihood of impacting by their strategically decisions.

Calculation of Beta values and expected rate of returns:

Particulars

Amount

Beta of the company

A

1.15

Risk Free Rate

B

4%

Market Risk Premium

C

6%

Required Rate of Return

D=B+[Ax(C-B)]

6.30%

The investment of company is determined by the value of beta and beta value being 1.15 indicates that investment strategy is aggressive. Value of beta is higher and it depicts that there is higher volatility along with higher return and higher risks. Investors who are risk averse would not like to make investment in this company.

Weighted average cost of capital:

Particulars

Amount

Weightage

Cost

Return Rate

Tax Rate

WACC

Total Long Term Debt

0

0.00%

0

0.000000000%

30.00%

0.00%

Total Equity

5826342

100.00%

6.30%

6.30%

TOTAL

5826342

100%

6.30%

It can be seen that there is no long-term debt attributable to company in the current year and hence cost of equity will be equal to weighted average cost of capital. Therefore, WACC is same of cost of equity of 6.30%.

WACC is the composite cost of capital that is used by investors in evaluating the project undertaken by company. This particular measure helps in forming estimation about organization’s expected cost. Computation of capital budgeting is the discount rate used by company. Whether company should undertake any project is terms of risk of compensation and return generated. Higher risks are generated by higher value of WACC and for undertaking additional amount of risks, investors should be provided with higher return (Hamza & Hassan, 2017).

Debt ratios for the past two years:

Debt ratios for the past two years of Metallic minerals stood at 0.072 and 0.050 for financial year 2016 and 2017 respectively. There has not been any stability in value of dividend and in the current situation; the capital structure of organization cannot be evaluated using the value of total equity (Graham and Sathye, 2017). It is so because company is incurring loss year after year and the company cannot seek any further long-term borrowing.

Dividend policy:

Dividend policy of Metallic minerals has been implemented in accordance with Corporation Act and as per rules that are listed on Australian stock exchange. Payment of dividend to shareholder have incorporated the guidelines and this ensures that share price of metallic mineral will be traded fairly. Payment of dividend has not been recognized in the financial statement for the year ending 30th June, 2017. As per the dividend policy of company, ordinary shareholders are entitled to participate in dividend payments. Company for avoiding any kind of compliance issues does principles prescribing the implementation of dividend policy (Chittenden and Derregia, 2015).

Letter of recommendation:

Dear XYZ

Queensland

Australia

Respected Sir,

I would like to give an opinion of making investments in shares of metallic minerals after conducting a detailed analysis and evaluation of company in terms of their capital, debt structure, financial leverage and share price. From the computation of ratios, it can be inferred that both return on assets and return on equity is negative and this is indicative of the fact that organization are not able to efficiently utilize their underlying assets and shareholders’ equity. Debt ratio has decreased in recent year because of decline in total value of liabilities. This depicts that liabilities are being paid and there is no further acquisition of long-term borrowing. Moreover, metallic minerals is generating year on year loss and this is not favorable for investors willing to make investment in this company (Minnis & Sutherland, 2017). Furthermore, share price of company has been highly volatile from 0.03 in year 2015 to end of year 2017. Therefore, investing in stocks of Metallic mineral would be risky and thereby it has the possibility of not generating favorable to investors in recent years.

Therefore, as part of recommendation to XYZ, investment in this company should be avoided and currently they should not involve shares of this company into their portfolio of investment.

Thanking you,

LMN

Investment Company

References

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