International Financial Management Assignment

Name: Hoang Lan Do Course module: International Financial Management Lecturer: Ibrahim Samai Assignment title: IFMGT Submission date: 28th June 2011

Index

Content Executive summary Introduction Economic risk assessment Sources of financing Repatriation issues Expropriation risk Conclusion References 4 4 5 10 13 16 17 19

Page number

ABREVIATION:
DRC: Democratic Republic of Congo IMF: International Monetary Fund THF: The Heritage Foundation MW: Mining Weekly TI: Transparency International WWF: World Wildlife Fund

Executive summary
The Democratic Republic of Congo is a country with immense natural resources. Mining is one of the predominant sectors of the countrys economy. Mining companies can benefit from government favourable policies for foreign investor such as incentives and reductions of taxes and custom duties, exempt of export duties, allowed transfer of dividends without restriction. However the government requires that the company has to submit an environment report, to support infrastructure, and to have a certain ratio between borrowed funds and equity. Despite of those favourable policies of the government to attract investors, investing in mining activities in this country present some high risks which involve the lost of value of investment, expropriation risk and high taxes on incomes due to the high level of inflation and public deficit, difficulties in transporting the mining exploited to seaports, license withdrawn and confiscated assets in case of disputes with authorities. Negotiations, join-venture with a state-owned company and buying insurance are strategies that can be adopted by BHP Billiton to prevent against certain risks when operating in this country.

Introduction
The Democratic Republic of Congo is the third largest country in Africa which is situated in the central of this continent. The development goals of Congolese government rely heavily on exports of some natural resources such as oil, gold, diamonds, manganese, iron ore, and wood products. High demand and high prices in mineral are encouraging the development of exploiting and extracting those resources in this country. Unfortunately, mineral extraction

has contributed many violent conflicts. The DRC nowadays is facing periodic outbreaks of fighting, unstable politics and corruption. BHP Billiton is considering investing in the Democratic Republic of Congo by foreign direct investment to mine and extract iron ore. This investment provides our firm possibilities to find raw materials to our manufacturing plant, a joint venture with a Chinese company. But all investments involve some degree of risk. Investing in Democratic Republic of Congo makes no exception. An analysis on risks that BHP Billition might face and strategies to protect against risks are essential for decision making of this investment.

I.

Economic risk assessment

In the first part of this report, we will analyze the business environment in the DRC which is necessary to assess the risks that might encounter the company. By necessity, this analysis not only focuses on economic factors but also political factors since politics usually have influences on economy. By analyzing those factors, we can have an idea on how well the country is doing economically. It is believed that The better a nations economic performance, the lower the likelihood that its government will take actions that adversely affect the value of companies operating there (Shapiro. A 2010 p.239). 1. Business environment analysis based on macro-economy statistics Democratic republic of Congo is one of the poorest less-developed countries in the world (rank 183/183 according to International Monetary Fund (2011)).
Democratic Republic of Congo Data Subject Descriptor GDP per capita - current prices Units U.S. dollars 2008 174.583 2009 162.385 2010 186.278

GDP per capita - PPP Inflation Public debt (General government gross debt as a % of GDP) Public deficit (General government net lending/borrowing as a % of GDP) Current account balance

U.S. dollars Percent change Percent of GDP

309.796 17.966 136.295

312.133 46.221 138.255

328.1 23.464 29.519

Percent of GDP

-3.275

-4.187

2.369

Percent of GDP

-17.464

-10.501

-6.84

Source: International Monetary Fund (2011)

The table above shows that there is an excessive government spending that the Congo public debt exceeded gross domestic product in 2008 and 2009. Government deficit is considered a risk indicator that investors should consider. The higher this figure the higher possibility that the government pay those debts by any way else than expropriations of property, raising taxes or printing money. These actions will have a great impact on the nations economic health and business environment. It is widely believed that they would decrease the investment value because budget deficit often leads to an increase in inflation. The Heritage Foundation (2011) asserts that The government has agreed to implement public-sector reforms aimed at more transparent fiscal management and stronger budget execution, but political pressure has held up such reforms in the past, and the administrative capacity needed to implement reforms is lacking. As a result, in 2010, there was a significant improvement in the Congolese government spending, the public debt fell as much as 110% of GDP to 29.5% of GDP. Congolese governments efforts in reforming public sector, fiscal management and budget execution have started to show positive results but theres still a long way ahead since the corruption in this country is perceived as pervasive (The Republic of Congo ranks 154nd out of 178 countries in Corruption Perceptions Index 2010 Results according to Transparency International (2011)).

Another indicator that we should consider before investing in the republic of Congo is inflation. According to the table below, the inflation rate in Congo is at a high level, 18% 46% and 23% in 2008 2009 and 2010 respectively. As we discussed above, inflation would lead to a decrease in investment value and to a devaluation of Congolese franc. When the Congolese franc depreciates, the incomes decreases in value. This would likely affect the objectives of our company to repatriate all of our profits back to Australia because of the issue of exchange rate. Management risks Besides those risks associated with the macro-economy of the DRC, we also discuss about management risks associated to the shipment of iron ore from the RDC to our joint-venture with Angang Steal in China. Those risks involve transportations, customs and tariffs.

Mining in the Republic of Congo

Source: UNEP/GRID-Arendal (2008)

Forest Cover in Democratic Republic of Congo

Source: Forest cover from TREES (EC Joint Research Centre), 2000 cited in WWF (2007)

The maps above show that the main mining activities situated in the North and the South Eastern part of the country where they are limited access by the forest and river systems.

Additionally the lacks of infrastructure may contribute some difficulties to the transportation of iron ore. The IMF (2007, p.36) stated that 70% of the roads and trails assessing agricultural areas are in advanced state of deterioration. Long distances to seaports combine with deteriorated routes and common vehicles theft make the transportation of iron ore difficult and the risk of losing merchandises is higher. Furthermore there are military groups which are not under control of the government. In addition, the security problem is another factor of risks in the process of transporting iron ore to export. The WWF (2007, p.21) noted that the scourges of corruption and informal governance have left the extractive industries vulnerable to local armed militia control, including incursions from groups based in countries bordering the DRC. This can be considered as a serious problem since the security of goods and companys staffs can be menaced by those militia groups. The DRC still lacks the political will and resources to ensure compliance with national and international norms and regulations. Another issues related to the shipment of iron ore to China are customs and tariffs. The DRC applies the Central African Economic and Monetary Community (CEMAC)s common external tariffs (CET). Under CEMAC, the member countries agree to establish free trade and reunite to a single market. Common instruments used by CEMAC countries to tax exports of minerals are export duties, royalties, an exit tax, a road tax on timber for export or in transit. The procedures of import and export are usually long and imposes many requirements. It requires in average 6 documents, 51 days clearing through customs and a cost of export of $1,924 per container for the export procedure (according to Olivia (2008, p.12) ).

Congolese tariffs code

Sources : Congolese authorities, WTO (2006) and IMF

According to the table above, the royalty rate on export of iron is 0,5% while access rights to exit is 2% , however export duties are exempted for iron ore (Craig Andrews et al., 2008 p.23). While export duties are favourable but the export procedures are long which is a substantial matter that we should consider for the process of shipment of iron ore to our joint venture in China.

II.

Sources of Financing

There are different methods of financing are possible to finance our $1 billion FDI project: reinvesting earnings, debt financing or equity capital from parent company BHP. We will examine the benefits and risks associated to each financing instrument.

1. Debt financing
Some of the best borrowing rates on business loans in Australia

Source: Interestrate.com.au (2011)

In case of debt financing, parent company BHP Billiton will provide an inter-company loan and charge costs to its subsidiary in Congo. The project loans will be raised from banks and capital market. Or the subsidiary itself has to borrow from international or local banks. However, many banks charge a premium for crossed-border lending compared to lending to the parent company. Above we have information about borrowing rates from Australian banks. The rates charged by Australian banks are from 7.09 percent a year, depends on institutions. BHP Billiton has also the possibility to borrow funds from local institutions, but it is necessary to provide credible guarantee.. Local and foreign companies have access to credit market in the DRC without discriminations. One the one hand, the benefits obtained by this way of financing are a total control over operations, management and essentially to hold proprietary, therefore enjoying fully the

returns on assets. On the other hand, financing a project through debts results in an obligation that must be serviced while cash flows depend on the projects degree of success. An important thing that we have to consider while choosing this financing instrument is that the RDC does not oblige a foreign company to create a joint venture with a local company but in case of 100 percent foreign owned, the company is required to transfer 5% of its share to the state in order to obtain a mining exploitation permit, according to Katshung (2011) which will
affect our control over the company and also the returns on this project.

2. Reinvesting earnings
The second financing option is reinvesting earnings. The net earnings of BHP will be retained and not be paid out as dividends to invest in this project. This will be recorded into shareholders equity on the balance sheet. Reinvesting earnings affect the capital structure of the company by increasing common equity relative to debt. Using retained earnings as funds does not lead to the payment of cash compare to debt financing. It can be considered as an attractive financing source because the investment can be undertaken without any outsider involve. Another important thing is this method of financing avoids a change in control of the company if issuing new shares. However it is highly depends on the dividend policy of the company. Shareholders are different between dividend and retention-generated capital gains. Some might prefer dividends because they are less risky, others might prefer retainedearnings which lead to capital gains and which is usually taxed at lower rates than dividends. If a net loss occurred is greater than beginning retained earnings, retained earnings can be negative, therefore create a deficit. Our projects value is estimated to be $1 billion so reinvesting earnings even it is chosen by the boards of directors, cannot be the only financing sources because of its insufficiency but this high-valued project requires other combining financing source. 3. Equity financing

Equity financing is the third option. The company raises cash by issuing equity shares which are not preference shares. The rate of dividend on equity share is not fixed and depends on the profits made by the company and the decisions by the board of directors. The equity shareholders have the right to vote on all matters relating to business and have an unlimited access to companys assets and profits. Equity is a long-term source of financing. The company does not require paying back the capital raised by equity during its life time. But this method of financing has some disadvantages for the company such as dilution in control, high cost and speculation. Issuing equity shares dilutes the voting powers of existing shareholder and extends the right to vote to new shareholders therefore the controlling powers over the company will be diluted. Certain equity shareholders can gather to manipulate the companys decisions. Besides, it costs more to raise funds with equity share than with other securities (obligations for example) as the selling costs and underwriting commission on the issue of these shares are paid at higher rate. Equity shares are transferable and they are subjects of speculation in the stock market which are not in the interest of the company.

A combination of those methods of financing might reduce the disadvantages of each source while benefit from its advantages. According to Deloitte (2011), Congolese Mine Law defines that a mining company must observe a ratio of less than 75/25 between borrowed funds and equity. It is important for the company to take into account that information to make a decision on financing sources. Financing by thin equity base and large proportion of external debts is preferred because of the reason of non dilution of capital, and as a result a long-term better control on company.

III.

Repatriation Issues

BHP wishes to repatriate all of its profits back to origin country Australia to distribute dividends to its shareholders. We will examine the issues surrounding this objective including taxation, environment, corporate responsibilities and policies on transfer of dividends.

1. Taxation of Mining sector in Democratic Republic of Congo According to Title IX of Congolese Mine Law 2002 (cited by Craig Andrews et al., (2008) p.23), the taxation regime includes different categories of taxes which are assessed by different government services such as : royalties which are 0.5 percent for iron metal; income taxes is 30 percent of imposable income; taxes on dividends is from 10 to 20 percent; expatriate employee tax is 10 percent of salary; surface rents due on minerals right is US$5.00 per hectare for exploitation; turnover tax is from 3 to 5 percent on interior services of products; taxes on land, built-up property ,taxes on vehicles and road traffic are at the common rate; mineral products except diamonds are exempt from customs duties upon export; taxes due on mineral concessions is US$0.02 to US$0.04 per hectare for exploration; annual surface rights payments for exploration permits for the first five years are calculated on escalating rates which is from US$2.55 to US$26.34 per square; annual surface rights payments for exploitation permits is US$424.78. There is an expected effective rate of taxation (ETR) which is used for preference to calculate the total predicted tax which is estimated to be around 46 percent of the projects cash flows before taxes (according to Craig Andrews et al., (2008) p.24). However, mining companies have lawful means of reducing taxes to be paid, for example, via transfer pricing mechanism (mining products is sold abroad to an entity affiliated with the mineral company which is our case of exporting products to our joint venture in China). It is important to note that Congolese government have some tax advantages and incentives to mining companies which are some reductions and exemptions from taxes and customs duties such as 10 percent

reduction of professional tax benefits, zero instead of 20 percent on loans contracted abroad in other currencies, 10 instead of 20 percent on dividends and other distributions (according to Katshung (2011)). Therefore, BHP Billiton has possibilities to minimize tax liability by legitimate and legal ways. 2. Local environment and corporate responsibilities of mining companies in RDC According to Craig Andrews et al., (2008, p.12), there are various legacy environment issues in the main mining areas such as waste dumps and tailing facilities which can harm to the nearby population. Besides, there are some claims on furnaces and processing plants are polluting the water supply. However, Congolese government does not have adequate environmental regulations. Another issue that BHP Billiton has to aware is corporate social responsibility. Under the Congolese Mine Law 2002, mining companies are required to submit an environmental impact report. Mining companies are also required to support infrastructure projects such as building schools, roads and hospitals. When operating mining activities in this country, environment and supporting infrastructure are significant issues that the company do not have to neglect. Therefore, the benefits from exploiting iron ore have to be partly used to protect local environment and supporting infrastructure as required by Congolese Mine Law. 3. Regulations on transfer of dividends in RDC According to Mia (2011, p.5), Congolese Investment Code allows for the transfers and other funds associated with investments. Furthermore, there is no restriction on reinvestment or on acquisition or turn-over. BHP Billion can freely repatriate as it wishes the benefits for distribution of dividends to shareholders in Australia. To do so, the company has to make an application which will be authorized within days.

IV.

Expropriation risks

Despite of efforts in stabilising the economy and measures taken to attract investors, the DCR is rated among countries with high risk for investors. Based on information from other companies, for example Canadian miner First Quantum Minerals whose license was cancelled in 2009, result of disputes with Congolese government. Therefore the company is aware of the possibilities of disagreement with local authorities and as a result mining license is withdrawn or assets are confiscated. First of all, to avoid future conflicts, it is better to anticipate future problems and have advanced negotiations. This includes negotiations on which funds maybe remitted (royalties, dividends, loans repayment etc...), the right to export to the 3rd country, obligation to support infrastructure, method of taxation etc... Otherwise, some other strategies might be adopted to protect the company against that kind of risks. The first possible strategy is the association through joint ventures with a state-owned company. Habitually those joint-ventures will have political influences on the government. The benefits of joint-venture are also benefits for the government. Mining license is guaranteed and risk of expropriation is avoided. Other possible strategy is to insure with an insurance company. This is the most common strategy that companies adopted to prevent against country risks. The Democratic Republic of Congo is a member of the World Banks Multilateral Investment Guarantee Agency (MIGA) and the African Insurance Trade Agency which provide political risk insurance for businesses operating in this country. Besides there are other companies which offer such insurance such as Overseas Private Investment Corporation, American International Group, Inc. (AIG), Ducroire Delcredere and many more. The insurance prime is habitually calculated based on each insurance company evaluation of the DRCs country

risk.(Reuters (2010) as cited in MW (2010)) Democratic Republic of Congo's political risk insurance premiums have risen 40 percent since a dispute over mining licences and are set to rise further as 2011 elections approach . This strategy is an efficient and safe way to prevent against country risk but it can be considered as a significant cost to our project.

Conclusion

The Democratic Republic of Congo is ranked among countries with highest risk for investors. This report has reviewed potential risks that might encounter investors, options of financing sources and strategies to protect against expropriation risk. The analysis led to the followings findings: High inflation, public deficit increase the risks of lost in value of the investment, expropriation of properties by authorities and raising taxes on incomes to payback countrys debts. Lacks of infrastructure and long distance from mining deposits to seaports make the transportation of iron ore exploited difficult. Other issues such as militia groups operating in mining areas and vehicles theft are not negligible. The procedures of export are usually long, and impose many requirements. Export of iron ore is subject to several taxes such as royalties and access right to exit, however duties are exempted. A ratio of less than 75/25 between borrowed funds and equity is required by the law. If the project is 100 percent foreign owned, the company is required to transfer 5% of its share to the state in order to obtain a mining exploitation permit. Financing by thin equity base and large proportion of external debts is preferred to not dilute the capital, and as a result a longterm better control on company.

Mining companies can benefit from incentives and taxes advantages such as some reductions or exemptions from taxes and customs duties. Submission of an environmental impact report and supporting infrastructure projects are required by laws for mining companies. Transfers of dividends are allowed without restriction on reinvestment or on acquisition or turn-over. Protecting against expropriation risk and license withdrawn by some possible strategies such as negotiating in advances, joint-venture with a state-owned company or buying insurance from insurance companies.

References List
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