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Finance — Practice Case 6
Case (90 minutes)
Today is March 16, 2020. Bob Johnson, CEO of Rock Mining Ltd. (RML), has been with
RML for the past five years. Prior to this, he was the CEO of an integrated forest
company that he successfully managed for seven years.
RML is a publicly traded, small-cap, Canadian company with a zinc mine in Manitoba
and a copper mine in Quebec. RML’s core competency lies in maximizing extraction of
ore at its mines. As a result of this process, RML’s production and administration costs
are consistently lower than the industry average. In 2019, RML reported a profit of
$7 million on sales of $120 million.
Bob has been investigating acquisition options and identified a number of possibilities.
After further research, Bob narrowed the choices down to two opportunities that he
considers a good fit for RML, which he has discussed with the board.
Woods Forestry Inc. — Share purchase
Woods Forestry Inc. (WFI) is a privately owned integrated forestry company. The
shares are currently for sale for $40 million. Bob met with the shareholder and
managers of WFI and prepared a summary of information, provided in Appendix I.
Extracts of WFI’s financial statements and notes are provided in Appendixes II and III.
Red Valley — Asset purchase
The Red Valley gold mining property, currently owned by Sudbury Xtra Gold Inc. (SXG),
is for sale for $11 million. This acquisition would be structured as an asset purchase.
SXG is currently looking to sell the Red Valley property to finance further exploration.
The Red Valley site has not yet been mined, nor has any infrastructure been built to
access the gold reserve. Additional information and select financial details of Red Valley
are provided in Appendixes IV and V.
While forestry and mining both fall within the natural resources industry, the underlying
risks of each sector differ. Betas for these two segments and additional pertinent
financial information are set out in Appendix VI. In addition, while the board of RML is
amenable to diversification outside of zinc and copper, it wants to proceed cautiously
and is only willing to consider one acquisition at this time.
Finance — Practice Case 6 Case
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One of the significant issues in mining is the requirement to remediate the land base
after the ore body is exhausted. RML is very experienced in estimating these costs for
mining properties, as it is part of its normal business. However, accurately forecasting
these types of obligations in the forestry sector falls outside RML’s area of expertise.
You, CPA, work for Valuation Expertise Group (VEG). RML has hired VEG to value the
two acquisition targets. Jen Brown, your team leader, has asked for your assistance and
has specifically asked you to do the following:
1. Calculate the appropriate capitalization/discount rate for each acquisition target and
explain the differences. Bob is uncertain what Beta represents and would like a brief
explanation.
2. Prepare a preliminary valuation calculation for WFI using the capitalization of free
cash flow method, using the five-year historical average, as at December 31, 2019.
Then discuss qualitative considerations that may also impact the decision.
3. Prepare a preliminary valuation calculation for the Red Valley property using the
discounted cash flow approach, assuming a valuation date of December 31, 2020,
as the investment will not be made until then. Follow this with a qualitative
discussion of considerations that may also impact the decision.
4. Recommend one of the alternatives based on your quantitative and qualitative
analysis. Consider comparing based on profitability indices.
Your response should be no longer than 2,700 words, excluding any Excel files.
Finance — Practice Case 6 Case
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Appendix I
WFI information
(As gathered by Bob Johnson in discussions with WFI management)
WFI started operations in British Columbia in 1974. While no forecasts of the future
prospects of WFI have been provided, revenue and costs have been stable for the past
five years and are expected to remain as such for the foreseeable future.
The executive team is very experienced, having been with the company for an average
of 23 years. WFI’s current expectation would be to retain the existing workforce after the
acquisition. However, RML would take a more hands-on approach.
Other relevant information:
• Sustaining capital expenditures, net of tax shield, are $5 million per annum.
• The present value of the tax shield based on the current undepreciated capital cost
(UCC) balance is $28 million.
• The owner has historically been paid a salary of $1,000,000. The market value of his
services is estimated to be $100,000 per year.
• WFI’s combined federal and provincial income-tax rate is 30%.
• Cash is considered redundant, and it is not required for ongoing operations.
Finance — Practice Case 6 Case
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Appendix II
WFI
Statement of financial position as at December 31
(Audited, prepared using IFRS)
(in $’000s)
XXXXXXXXXX
Assets
Current assets
Cash and cash equivalents $ 2,321 $ 1,220
Accounts receivable — trade 8,890 8,540
Inventories 11,780 12,080
Total current assets 22,991 21,840
Property, plant, and equipment, net 38,222 38,560
Timber licences 19,543 20,561
Other intangible assets 8,890 8,540
Total assets $89,646 $89,501
Liabilities
Current liabilities
Accounts payable and accrued liabilities $ 3,141 $ 3,444
Current portion of long-term debt (A) 7,512 7,488
Current portion of deferred reforestation obligations 3,744 3,165
Total current liabilities 14,397 14,097
Long-term debt (B) 27,278 30,350
Deferred reforestation obligations 7,731 7,919
Deferred income taxes XXXXXXXXXX
Total liabilities 50,249 53,208
Shareholders’ equity
Share capital 12,000 12,000
Retained earnings 27,397 24,293
Total equity 39,397 36,293
Total liabilities and equity $89,646 $89,501
Total long-term debt (A + B) 34,790 37,838
Finance — Practice Case 6 Case
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Appendix II (continued)
WFI
Statement of profit or loss for year ended December 31
(Audited, prepared using IFRS)
(in $’000s)
XXXXXXXXXX2015
Sales $85,973 $84,287 $82,634 $81,014 $79,425
Expenses
Manufacturing and product costs 54,163 54,365 54,125 51,849 50,435
Freight and other distribution costs 14,862 13,305 12,481 12,568 11,322
Depreciation and amortization 5,335 5,652 5,494 5,976 5,600
Selling and administration costs 3,944 3,884 3,747 3,180 3,423
78,304 77,206 75,847 73,573 70,780
Operating income 7,669 7,081 6,787 7,441 8,645
Finance expense, net 1,893 1,345 1,282 1,220 1,120
Net profit before income taxes 5,776 5,736 5,505 6,221 7,525
Income tax expense 1,733 1,721 1,652 1,866 2,258
Net profit $ 4,043 $ 4,015 $ 3,853 $ 4,355 $ 5,267
Finance — Practice Case 6 Case
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Appendix III
WFI
Extracts of notes to the financial statements
For the year ended December 31
(in $’000s)
Long-term debt
The fair value of total long-term debt at December 31, 2019, roughly approximates the
book value of $34,790.
Reforestation obligations
WFI has reforestation obligations amounting to $11.475 million at December 31, 2019.
The total undiscounted amount of the estimated cash flows required to settle the
obligations at December 31, 2019, was $12.690 million. The estimated cash flows have
been adjusted for inflation and discounted using pre-tax adjusted risk-free rates ranging
from 1.1% to 2.3% at December 31, 2019.
Finance — Practice Case 6 Case
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Appendix IV
SXG Red Valley information
(As gathered by Bob Johnson in discussions with SXG management)
The technique for extracting gold from the ore body is similar to that of removing copper
and zinc. A geological survey performed by My Geological Consultants Inc. (MGC)
indicated that the current market value of proven gold reserves at the Red Valley site is
US$514 million, as detailed in Appendix V. However, RML recently learned that MGC is
wholly owned by an investor who also owns 15% of SXG.
RML’s management has provided estimated mining costs and other relevant data as
detailed in Appendix V. Cash flows are expected to be earned evenly throughout the
year.
Development costs and special tax treatment
The $11 million purchase price of the mining property includes the land and permits. It is
expected that the mine will be ready to start production on January 1, 2021, after RML
spends $10 million to build the necessary infrastructure and $20 million to purchase
new equipment.
For income-tax purposes, the $11 million purchase price for the property qualifies as a
Canadian Development Expense (CDE), the $10 million of costs for infrastructure
qualifies as a Canadian Exploration Expense (CEE), and the $20 million of costs for
mining equipment qualifies as Class 41(a) assets.
100% of EBITDA in 2021 and 2022 is expected to be sheltered from tax via these CDE,
CEE, and CCA deductions. In 2023, $10,645,000 of EBITDA is expected to be
sheltered from tax, followed by $1,132,000 in 2024, and $792,000 in 2025. Further,
recapture on assets disposed of in 2026 is expected to be $4,151,000.
Disposition of mining property
It is estimated that the equipment can be sold for proceeds of $4 million when the
project is complete. Once production is complete and the site has been remediated, it is
expected that the mining property can be sold for $2 million.
Finance — Practice Case 6 Case
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Appendix V
Supporting information for the Red Valley gold mine
Geological survey
Proven gold reserves (kilograms) 11,900 kg
Current market price XXXXXXXXXXof gold per kilogram (US$’000s) $43.20 /kg
Total value (US$’000s) $514,080
Estimated cash costs per RML’s management team (in $’000s)
Extraction costs per kilogram of ore $25.2 /kg
Processing costs per kilogram of ore $10.0 /kg
Administrative costs per year $950 /year
Inflation rate for administrative costs beginning in XXXXXXXXXX%
Inflation rate for production costs beginning in XXXXXXXXXX%
Capital costs to initiate operations (in $’000s)
Mine purchase (based on the offer price) $11,000
Infrastructure costs $10,000
New equipment cost $20,000
Working capital requirements $5,000
End-of-life cash inflows (outflows) (in 2026 — $’000s)
Land remediation cost $(2,500)
Proceeds on sale of land site $2,000
Proceeds on sales of equipment $4,000
Extraction prediction per year in kilograms
2021 1,400 kg
2022 2,100 kg
2023 2,300 kg
2024 2,500 kg
2025 2,300 kg
2026 1,300 kg
Proven gold reserves 11,900 kg
Estimated future gold prices per kilogram (US$’000s) USD
Average for 2021 $44.50 /kg
Average for 2022 $43.61 /kg
Average for 2023 $44.05 /kg
Average for 2024 $44.49 /kg
Average for 2025 $45.38 /kg
Average for 2026 $46.29 /kg
Average expected exchange rate US$ = CDN
2021 US$1 = 1.03 CDN
2022 US$1 = 0.98 CDN
2023 and beyond US$1 = 1.02 CDN
Finance — Practice Case 6 Case
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Appendix VI
Supplementary financial information
The board believes the modified capital asset pricing model is the most relevant for
determining the cost of equity. The following information has been gathered to help
determine the appropriate discount factor.
Financial market information
Expected market risk premium (Rm – Rf) 6.0%
Risk-free rate 1.9%
Betas for comparable public companies
Gold mining 2.1
Forestry 1.8
RML 2.0
WFI financial information
Cost of debt 5.0%
Target debt-to-equity ratio 1.2:1
Specific company risk premium 3.0%
Constant future growth rate 1.5%
RML financial information
Cost of long-term debt 6.0%
Target debt-to-equity ratio 1.5:1
Red Valley mine site risk premium 6.0%
Taxation information
• RML’s combined federal and provincial income-tax rate is 25.0%.