Southport Investment Opportunity Case Study Solution
Evaluation of Alternative Valuation Approaches
The valuation approaches adopted by the Southport management are based upon different discount rates. A summary of four different valuation approaches is given in Exhibit B. It can be seen from Exhibit B that the both, Approach 1 and 2 would undervalue the project because the basis for discount rate assumed under both the approaches is the cost of capital of Southport Minerals, which has a different capital structure i.e. 100% equity, as compared to the SI’s capital structure. As cost of equity is non-tax deductible, therefore, the discount rate of 15% and 20% under both the approaches respectively would undervalue the project.
As compared to the approaches 1 and 2; Approach 3 of discounting cash flows at SI’s WACC creates more rationale. As, the Southport Minerals would have no obligations for the debt payment of SI, therefore, considering the discount rate of Southport Minerals would not be feasible. The SI is a standalone business unit of Southport Minerals, therefore all the cash flows from the SI should be discounted on the SI’s WACC. However, it would overvalue the project a little as the actual cash flows for the equity would be dividends. (Morfin, 1983)
Although, dividend approach is an aggressive approach for the project valuation, and it could be used in evaluating the sensitivity of the business, but it possesses less rationality than the approach 3, which is an excessively used approach for project valuation.
Suggested Valuation Method
The most rational valuation method is the Discounted Net Cash Flows after tax, as it considers all the expenditures related to a business. However, the rate for discounting the net cash flows can impact the overall valuation of the project. The recommended rate for discounting the net cash flows is the SI’s WACC. The suggested valuation method would consider the cost of debt to the lenders in terms of interest and it would also consider the rational rate for discounting.
Valuation of the Project
The valuation in the attached spread sheet is conducted by using Discounted Cash flows with zero terminal value of the project, and a discount rate of 14.6% including SI’s WACC and a 7% margin show that the project has a positive NPV of 141.48 million,and is having an IRR greater than the Southport Minerals’ cost of capital i.e. 18%. On the basis of above calculations, the company is recommended to make an investment in the project.
Sensitivity Analysis
The sensitivity analysis conducted on the basis of declining copper prices by 10% shows that the project would have a positive NPV of $123.11 million even after reduction in copper prices. The NPV would become zero if the copper prices would decline at the level where it would reduce the total present value of inflows by 21.48 million, which is a huge margin of safety for the project in terms of declining copper prices.(Brigham, 2016)
Conclusion
Although, the company faces several problems in terms of using an optimal discount rate for the valuation of the First burg Project, but it can be seen that the project is non-feasible under only one approach with highly aggressive irrational discount rate. The suggested discount rate for the cash flows is SI’s WACC with a margin of safety. The project shows a positive NPV even after the reduction in Copper prices under sensitivity analysis showing that the project would be feasible in economic downturns as well.
Exhibits
Exhibit A: Summary of Financing Arrangements
| Financing Arrangement | Amount (in $ millions) | Interest Rate | Payment Period | Guarantee | Additional Contracts |
| Japanese Loans | 20 | 7% | 1975-1980 (3.3 million per year) | The Export-Import Bank of Japan | The Japanese Smelter would buy 2/3 of the total output. |
| German Bank Loans | 22 | 7% | 1974-1982 (escalating installments) | Federal Republic of Germany | Buyout of 1/3 of total output |
| US Banks Loans | 18 | 7% | 1974-1976 | US Export-Import Bank | SI to purchase $18m US manufactured equipment |
| US Insurance Companies Loans | 40 | 11% | 1975-1982 | Overseas Private Investment Corp. | SI to purchase $40m US manufactured equipment |
| Equity | 20 | N/A | N/A | Overseas Private Investment Corp. | N/A |
Exhibit B: Summary of Valuation Approaches
| Approach | Discount Rate | Discount Rate % | NPV (in $ millions) | Overvalue/ Undervalue |
| Approach-1 | Southport Minerals Cost of Capital | 15% | 2 | Undervalue |
| Approach-2 | Southport Minerals Cost of Capital + 5% Risk Adjustment | 20% | (17) | Highly Undervalue |
| Approach-3 | SI cost of Capital | 7.6% | 58 | Overvalue Cash Flows Generated by Equity |
| Approach-4 | Dividend Paid Discounted at 20% | 10 | Undervalue |
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