Part four of a research report

4. The nature of the firm’s capital structure determination policy

The company’s capital structure is the mix between the debt and equity financing for long-term purposes. Capital structure is a vital aspect of a company’s strategic plans as it may affect the firm’s valuation (Harris & Raviv, 1991). The businesses that are highly leveraged are considered to be riskier hence valued lower than companies which are less leveraged. An optimal capital structure may command a high market price per share among other commercial benefits.

For the year ended 2015, Fortescue Metals Group Limited made a net income of US$316 m with E.P.S of 10.18 cents far much lower than the E.PS made the previous financial year. The earnings per share declined by about 88% with a similar decline in profits as well. This decrease in these essential parameters is largely attributed to the global fall in iron ore price by about forty-one percent.

Fortescue Metals Group Limited has established a capital structure which is very flexible with highly flexible maintenance agreements or no covenant at all. The earliest debt for the company is maturing at the beginning of 2019. In the financial year ended 2015, Fortescue made a repayment of US$500 million voluntarily of a debt under unsecured notes whose maturity was 2018. The maturity period was pushed to 2019 through another financing of US$2300 million. This time, this was under senior secured notes for full recovery of the balance in 2017 and 2018 including a partial recovery in 2019 financial year for senior unsecured notes.

part four of a research report

Chart 1: Fortescue capital structure

Financing these debts has been possible through the steady cash flows which have remained consistent in the last six years. These regular cash flows have been sustained through being focused on reducing the cost of production, meeting the set production goals and targets as well maintaining a disciplined capital structure and management.

During the financial year 2015, FMG concentrated on expanding its capital so as to raise the production capacity to required market levels. The fiscal year 2016 is estimated to consume about US$ 2/WMT, which is majorly on supporting the current operations. The cash and cash equivalents (net cash flows) amounted to US$2,381 million as at 30th June 2015 a slight decline from 2014’s US$2,398 million. An evaluation of the cash flow movements is as follows:

• For the financial year 2015, working cash flows amounted to US$2,037 million, a decline from the previous year of US$6,248 million. As earlier mentioned, the drop in the prices of iron ore is attributed to this fall in performance. The impact of the iron ore prices was so significant that it could not be avoided by alternative means.

• Reduction in the mines was a successful strategy yielding US$623 million of the operating investment.

• Delivery of iron ore led to the amortization of US$669 million which is counterpoised by US$500 million conceived during the financial year. This resulted in net reduction in client repayments.

• The tax paid during the fiscal year ended 2015 was US$529 million. This is the tax for the financial year ended 2014.

• There was a great reduction in financing cash flows from US$1,392 million in 2014 to US$726 million in the fiscal year 2015.

There are factors which led to the cumulative financing outflows experienced in the financial year ended 2015 of US$1,235 million down from US$4,625 million in 2014 which include:

• US$500 million repayments of 2019 senior unsecured notes. These were done earlier than the stipulated date.

• Full redemption of 2017 and 2018 senior unsecured notes including partial redemption in 2019 all amounting to US$1980 million. The balance of the proceeds was reserved to pay for 2019 early retirement of senior unsecured notes amounting to US$ 320 million.

• The total finance cost and interest paid in the year amounted to US$605 million, a slight decrease from the previous year of US$853 million

• Dividends paid during the year amounted to US$343 million with an extra payment of 10cents (Australian) final dividend

The above cash flow analysis describes the reasons behind the decline in the profits reported by FMG in the financial year 2015. The combination of debt and equity as shown in Chart 1 shows the company has a solid financing plan. With the current cash flows estimated to remain the same or increase in the future, the future capital policy for FMG is predicted to take a stable form.

The gearing ratio remained the same at 56% with the return on equity dropping to 4% from 42% in 2014. This shows that the market price per share might be affected by the same magnitude. The plan is viable in the long run as the operations will run smoothly with improved production capacity. The adverse effects of this decline in return on equity will only be felt in the short term although the future capital structure is not affected (Harris, and Raviv, 1991. If anything, it is enhanced, and the firm has a relatively stable future capital structure (Ju, et al., 2005). FMG’s capital structure directly resembles that illustrated in the trade off capital structure theories. FMG has used the debt policy in such a way that it balances its costs and resulting benefits thereof.

References:

Fortescue Metals Group Limited. (2014). Fortescue 2014 Annual Report.

Fortescue Metals Group Limited. (2015). Fortescue 2015 Annual Report.

Harris, M., & Raviv, A. (1991). The theory of capital structure. The Journal of Finance, 46(1), 297-355.

Ju, N., Parrino, R., Poteshman, A. M., & Weisbach, M. S. (2005). Horses and rabbits? Trade-off theory and optimal capital structure. Journal of Financial and Quantitative Analysis, 40(02), 259-281.