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Case Study: Molycorp: Financing the Production of Rare Earth Minerals (MCP)
Group 1
Would you buy Molycorps shares at USD 11.49 per share in August 2012? Present
the arguments for and against buying at this price.
1. REEs (rare earth elements) are unique, scarce and important (p1 in case).
The demand for rare earth elements has risen substantially in the last 60 years
because of their unique electrical, mechanical and magnetic properties.
REEs are critical inputs to many technologies ranging from defence
applications to clean energy to your smartphone.
by the company's total book value from its balance sheet. Book value
is also the net asset value of a company, calculated as total assets
minus intangible assets (patents, goodwill) and liabilities.
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Group 2
The company owns the only rare earth mine in the western hemisphere with
significant deposits etc.
This strategy had two key parts: A) the modernisation and expansion of the
Mountain Pass facility, known as Project Phoenix; B) the acquisition of downstream
refining and manufacturing capabilities.
Completion Risk: Can MCP complete Project Phoenix cost and schedule
overruns, cost increase; but Analyst says the project
remains on budget and on time (p6)
3
Financial Risk: MCP has high leverage above its target leverage ratio
(p5, X-10, Table C):
ASK THE CLASS: what is the most significant risk facing Molycorp? Funding risk.
MCP needs more capital to finish project Phoenix and may not be in a good
position to raise more capital. It needs funds for debt service and capital
expenditure (capex). The fact that REO prices have fallen substantially (see Ex 1)
has left MCP unable to generate much operating cash flow to fund the project
internally. As a result, it will need to raise external finance exactly at the time its
prospects are not very appealing to some/many investors.
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Group 3
We now need to focus on this need to raise capital. How much and what kind? To
do this we need to start by assessing where Molycorp is in terms of its capital
structure.
Q1
Exhibit 10 says MCP two year average market value leverage ratio (Debt / Value)
was 7.6% compared to a target market value leverage ratio of 20-30% (p5).
Q2
4
Using data from Exhibit 4, you can calculate the current leverage ratios which are
far in excess of target (20-30%, p5) at least after the recent stock price decline, and
far in excess of the most comparable peer firm (Lynas Corp): 46.% vs 19.5%.
As at 30 June 2012, Lynas was at the lower end of its target range and Molycorp
was at the upper end of the target range.
Q3
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Group 4
1. To become operational and implement its business plan, how much external
capital must Molycorp raise between July & December 2012?
2. What is its financing need in 2013?
3. Analyse the firms sources and uses of cash.
4. What funding alternatives are available to Molycorp?
5. Should Molycorp issue debt, equity or a combination of both? Explain your
reasoning and discuss the relative merits of each funding alternative.
6. How should MCP approach making this decision?
Q1
To answer this we need to analyse the current sources and uses of cash. See
spreadsheet L3 Cash Sources & Uses Aug Dec 2012.
Q2
Q3
If Project Phoenix gets completed and comes on line, the expected cash flows are
substantial and the cash needs relative low .. at least according to the forecasts in
Exhibit 9 (which contain some assumptions).
MCP needs to raise $500m to funds its obligations for the second half of 2012. The
need for extra funds stems mainly from the following: capex required to complete
Project Phoenix USD 289m; repayment of debt ($263m = $230m convertible debt +
5
$33.2 million of other debt, page 5; investment in net working capital ($202 m)
associated with the Mountain Pass mine becoming operational; and interest
expense ($36.24 .. see TN Table E page 8).
Q4
Qs 5 & 6
Given the need for $500m, the company will have to use both equity and debt.
The simple answer is that MCP should choose the alternative(s) with the lowest cost,
where the cost include the direct cost as well as the impacts of costs such as
financial distress, signalling and under pricing.
Start by looking at the capital structure relative to the target capital structure. We
have already been given this data. I refer to the current market value leverage
ratio which is 46.5% and the target is 20-30% (page 5).
The companys leverage ratio is well above its closest comparable, Lynas Corp
(19.5%). THEREFORE MCP seems to be overleveraged in both absolute and relative
terms.
If MCP raised $500m of additional straight debt, it would increase its leverage ratio
to 56% (TN Ex 3). BUT if MCP issues $500m of equity, its leverage ratio would fall to
38% (assuming no change in the share price); this is still way above its target range.
This suggests that MCP should consider issuing equity to sort out its funding crisis, and
at the same time improve its leverage ratio. However, we must consider that the
share price is likely to fall in response to the decision to issue equity (a signalling
effect) and thus diminish the reduction in the leverage.
We also need to consider that MCPs share price has fallen from $77 in May 2011 to
$11.49 in Aug 2012. Given this, it is possible that the current market price may not
reflect the firms fundamental value. If the market is currently undervaluing MCP,
perhaps because investors have overreacted to the bad news, issuing equity could
be very expensive.
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Group 5
6
1. To what extent does Molycorp need tax shields? Discuss the static trade off
theory of capital structure.
2. Molycorps share price has fallen from a high of USD 77 in May 2011 to USD
11.49 in August 2012. Is the market under or over valuing the company?
3. Explain why the market is under valuing Molycorp.
4. Explain why the market is over valuing Molycorp.
Q1
See TN exhibit re capital structure & debt to equity trade off. The curve shown
provides a chance to review the static tradeoff theory of capital structure (debt
has the advantage of generating incremental interest tax shields and the
disadvantage of generating incremental distress costs).
To what extent does MCP need tax shields today versus in the future?
How costly is financial distress, especially for an unproven and incomplete facility?
Are there other factors such as flexibility or control over free cash flow that better
explain MCPs current and its target capital structure? EG to what extent are
investment decisions affected by the presence of long term debt in the capital
structure? AGENCY COST ISSUES. Shareholders may not invest if they think that
profits will be used to pay off existing debt holders.
It is highly likely that financial flexibility and credit ratings are the most important
debt policy factors.
Q2
It is possible that $11.49 does not reflect the companys fundamental value.
If the market is undervaluing MCP, it may be because investors have over reacted
to the bad news. This means that issuing equity could be extremely expensive.
It is also possible that MCP is undervalued following the release of the poor second
quarter results for 2012 and the need for additional financing there is plenty of
behavioural evidence that shows individuals are prone to overweighting recent
information.
If the market is overvaluing MCP, this would be a point in favour of issuing new
equity.
7
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Group 6
SEE SPREADSHEET.
What do the results of this sensitivity analysis tell you? Ans: a systematically risk
company.
The Asset Betas are the unleveraged equity betas for the two companies. The
asset beta is a proxy for the business risk of the project.
Business risk represents the uncertainty in the projection of the companys cash
flows which leads to uncertainty in its operating profit and then uncertainty in its
capital investment requirements.
The Equity Betas reflect both the business risk of a companys operations (asset
beta) AND the financial risk (leverage) of the company.
Financial risk represents the additional risk placed on the common shareholders as
a result of the companys decision to use debt i.e. financial leverage. This is
because with the addition of more debt to the structure the residual claim of the
shareholders becomes less certain and hence more risky.
8
If a companys capital structure is 100% equity then beta would only reflect business
risk. This is because there is no debt in the capital structure. And in such a company
analysts may refer to the beta as asset beta.
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Group 7
1. Review Molycorps financial projections and calculate the free cash flows
and terminal value. Most of the data inputs are in the case.
2. Discuss whether you believe that the projections are reasonable. What, if
any, changes would you make and why? How could the various business
risks, discussed at the beginning of this case, impact the analysis?
3. Calculate Molycorps total enterprise value.
4. Calculate Molycorps common equity value per share.
5. Prepare a sensitivity analysis of Molycorps Common Equity Value using the
following data:
WACC inputs: 13.3&; 14.2%; 14.7%; 15.2%; 15.8%
Terminal Value Growth Rate: 0.0%; 1.4%; 2.2%; 3.0%; 4.0%
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Group 8
The valuation of the convertible debt alternative is achieved by adding the values
of the bond and option components together.
1. Identify the nine assumptions and inputs to calculate the value of the
convertible bond. Assume a Discount Rate for Bond Cash Flows of 11.3%. All
other assumptions and inputs can be found in the case on p5 & one on p 7.
2. Over a 10 year time period, inclusive, and using data from No.1, work out the
following for each year:
Bond Cash Flows
9
Discount Factor
Present Value
3. Compute the Value of the Bond Component.
4. Value of the Option Component.
DCF Value per Common Share: $7.00; $10.00; $11.49; $13.00; $16.00
Volatility: 45%; 50%; 55%; 60%; 65%; 70%; 75%