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________________________________________________________________________________________________________________ HBS Professor William E. Fruhan and Professor Wei Wang, Queens University, Kingston, Ontario, prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. Although based on real events and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entities is coincidental. Copyright © 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

W I L L I A M E . F R U H A N

W E I W A N G

New Earth Mining, Inc.

Company Background

It was the beginning of 2013. After gold prices experienced an unprecedented boom from $300 per ounce to $1,700 per ounce in the previous decade, Denver-based New Earth Mining, one of the largest U.S. precious-metal producers, was enjoying rapid growth in earnings. With the continued improvement of its operating margins, New Earth had accumulated a large amount of cash on its balance sheet (Exhibit 1). It had a simple debt structure and a reasonable leverage ratio with no significant risk of liquidity.

Most of the company’s mines were located in the U.S. and Canada, but like many other firms in the precious-metals industry, New Earth had made substantial investments in gold exploration projects in other countries such as Australia and Chile. However, like many industry participants, New Earth executives worried about the sustainability of gold prices at their current levels. With its strong financial condition and the desire to diversify its business through new capital investments rather than acquisition, New Earth felt it was necessary to implement a diversification program that would reduce its dependence on precious metals. The company started investigating the possibility of diversification in base metals and other minerals.

New Investment Opportunity in South Africa

A new investment opportunity appeared in early 2012. New Earth was informed of the existence of a major body of iron ore close to the massive Kalahari manganese field in the Northern Cape of South Africa by an independent exploration consulting company. New Earth felt an investment in iron ore provided a strategic fit for its diversification objective.

Since steel represented almost 95% of the metal that was used in the world, iron ore was arguably more integral to the global economy than any other mineral. The price of iron appreciated more than five-fold from 2002 to 2012 (see Exhibit 2). Unlike the price of gold, for which there was considerable

9 - 9 1 3 - 5 4 8 R E V : O C T O B E R 1 1 , 2 0 1 3

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913-548 | New Earth Mining, Inc.

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

speculation, the price of iron ore was not expected to fall dramatically given the strong global demand for the commodity. According to a 2012 report by the U.S. Geological Survey, the world iron ore market would continue to be tight, with demand exceeding supply until at least 2016. This was due to the long lead times required to bring mines into production, a world shortage of skilled labor, and growing natural resource nationalism, which reduced exports from some nations. Given that the price of iron ore had appreciated dramatically after 2007 and was expected to stay above $80 per metric ton, New Earth decided to evaluate the feasibility and profitability of developing the Kalahari mine.

New Earth hired Drexel Corporation, an engineering and construction firm, to analyze the extent of the deposit and to determine the cost and feasibility of establishing a mine site close to Kalahari. The engineering firm found that the field contained 30 million tons of ore with an average iron content of 60%. At the projected extraction rate of 2 million tons per year, it would take 15 years to deplete the ore body.

Drawing in part on its earlier evaluation of an iron ore project in Sishen, South Africa, Drexel estimated in October 2012 that the proposed venture in South Africa could be operational by the beginning of 2015. Drexel reported that there was limited need for infrastructure investment to support the development of the mine, and the total investment cost was estimated to be $200 million with 40% of the investment required at the beginning of 2013 and the rest required at the beginning of 2014. This investment amount would include construction costs and related insurance, operational costs, and $20 million in working capital. Ore would be trucked to Durban and railed to Port Elizabeth in the Eastern Cape for export. Given the high quantity of iron contained in ore mines in South Africa and the easy access to ports from the mine location, the venture was expected to have low production costs.

By November 2012, New Earth was able to produce pro forma analysis on the profitability of this new investment (Exhibit 3). The analysis revealed that the investment opportunity had attractive potential. At an assumed price of $80 per ton, the investment opportunity promised strong cash flows. The project would produce even stronger cash flows given an optimistic price forecast of iron ore at $100 per ton. New Earth also performed a sensitivity analysis to analyze the impact of various discount rates and iron ore prices on the net present value of the project’s cash flows (Exhibit 4). Despite its initial attractiveness, the project carried some substantial risks that New Earth needed to consider.

Market for Iron Ore

Iron ore was consumed predominantly by the steel industry. China, Japan, and South Korea were among the top countries in both iron ore imports and steel production (Exhibit 5). In 2010, China imported almost 60% of the world’s total iron ore exports. Japan and Korea were next among the top importers. During the previous decade, world seaborne demand in iron ore had doubled since 2000. According to BHP Billiton, one of the world’s largest iron ore producers, global seaborne iron ore trade was expected to grow steadily over the next decade, at an annualized rate of 4.4% per year. Also, according to AME Mineral Economics, an independent research house on commodities, crude steel production in these three Asian countries was expected to grow more than 35% in the next decade.

New Earth Mining, Inc. | 913-548

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

South Africa

According to the U.S. Geological Survey, as of the beginning of 2012, South Africa was ranked 14th in the world in iron ore reserves, with an estimated one billion tons of crude ore. Additionally, South Africa was ranked as the 7th largest producer of iron ore in the world (Exhibit 5). Most of the country’s reserves were located in the Northern Cape Province in the large Kalahari manganese field, close to the Botswana and Zimbabwe borders. Saldanha Bay was one of the primary ports used to export iron ore, with more than 34 million tons passing through it each year. Because South Africa was positioned to be one of the major exporters to Asia, significant construction efforts had been put into building new ports and facilities for ore exports.

New Earth was worried about a number of risk factors associated with making a large investment in South Africa. The political system was unstable and corruption was a major ongoing concern. Industry experts ranked it as one of the top countries in terms of political risk affecting mining operations. High risk of civil war in neighboring countries was a constant threat. Furthermore, there existed the ongoing fear with all less-developed countries such as South Africa that the government would nationalize natural resource operations.

Fortunately for New Earth, multiple countries including China, Japan, and South Korea were extremely supportive of the assurance of long-term supply of raw materials to their domestic steel producers as steel production was vital to their economic growth. Their governments had provided various forms of credit guarantees to mining operations in a number of less-developed countries. These guarantee programs made it possible for New Earth to protect itself against the significant political risk embedded in the South African venture.

Negotiating a Financing Package

By December 2012, New Earth had tentatively secured a few large steel producers located in China, Japan, and South Korea as major customers. Iron ore would be shipped to these countries via seaborne trade. The two steel producers in China were contractually obligated to purchase half of New Earth’s Kalahari iron ore output while those in South Korea and Japan were contractually obligated to purchase the other half. The purchase would be settled at the ore market price at the time of the ore shipment. New Earth would form a new subsidiary, New Earth South Africa (NESA), to undertake the mining operation. It had tentatively negotiated a financing package with the potential customers and a syndicate of U.S. banks for its South African venture.

Of the $200 million needed to complete the project, $100 million was tentatively negotiated with the overseas buyers. The two steel makers in China agreed to lend NESA $60 million in senior subordinated debt at 9% interest. This loan would be repayable at the rate of $8 million per year between 2022 and 2028, with the final $4 million paid down in 2029. The loan was guaranteed by the People’s Republic of China. A comparable financing agreement was arranged with the group of steel makers in South Korea and Japan. To induce NESA to sell half of the iron ore output to the companies based in these two countries, a large Japanese bank and Export–Import Bank of South Korea agreed to jointly provide $40 million senior unsecured debt at an interest rate of 7%. This loan was payable between 2016 and 2026 at a decelerating rate (Exhibit 6), and was guaranteed by the central banks in these two countries.

New Earth turned to domestic lenders to obtain the remaining financing necessary for the South African investment. A group of U.S. banks tentatively agreed to provide a syndicated bank loan worth $60 million, repayable between 2016 and 2023 to NESA. The senior bank loan would carry a

913-548 | New Earth Mining, Inc.

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

10% interest rate and be collateralized by the mining equipment, which would be purchased from a large U.S. manufacturer. An export facilitating arm of the U.S. government agreed to guarantee this loan. In total, $40 million worth of loans were to be provided at the beginning of 2013 and $120 million worth of loans were to be provided at the beginning of 2014. Repayments were to be made starting at the end of 2016 (Exhibit 6). In addition, no interest was to be paid in 2013 and 2014. The interests accrued in those years would be payable at the end of 2015 with no interests compounding.

Various loan covenants were embedded in the financing package. After deducting interest and contractual debt repayments, NESA would use all remaining discretionary cash flow for prepayments of debt and the issuance of dividends. The amount paid out in dividends was not to exceed the amount allocated to prepayment of debt. Both senior secured and unsecured debt was to be paid in full before junior debt, according to the debt prepayment schedule. The actual amount of prepayment to each class of senior debt was proportional to the original principal amount. Finally, no dividends could be paid to New Earth until December 31, 2016.

To complete the investment, New Earth would invest the remaining $40 million in NESA as equity capital, at the beginning of 2013 (Exhibit 7). The National Assurance Corp, an insurance company backed by the U.S. government, guaranteed New Earth’s investment in South Africa against potential losses due to civil war and government nationalizing natural resource assets. To further protect its investment, New Earth struck a deal with all its financing parties. It was agreed upon with each party of the proposed $160 million debt financing that in the event of a cost overrun, the amount of capital supplied would automatically increase by up to 25% on a pro rata basis for all lenders. Hence, the project would be guaranteed for $240 million investment before New Earth would have to resort to additional funding. The mining operation would be carried out solely by NESA, the new subsidiary, which would further protect New Earth against potential liabilities. New Earth would not have to guarantee nor be responsible for NESA’s debt obligations.

Project Valuation

The tentative financing package arranged by New Earth had the potential to turn an otherwise unattractive project into a profitable investment opportunity. However, the complex financing plans created some challenges for New Earth in evaluating the investment worth of the new project. Four different valuation approaches were proposed. Each valuation approach had a different champion. These included the vice president of operations, the accounting officer, an outside consulting firm, and a financial analyst within the firm. The CFO of New Earth was considering all available approaches to determine the correct valuation of their South African venture.

Approach 1 – VP of Operations

The VP of operations called for discounting the projected cash flows to be generated at NESA by New Earth’s 14% weighted average cost of capital, which is obtained as the weighted average of the cost of equity (15%) and the cost of debt (10%) with leverage assumed to be at 12% of the capital structure. All specifics on financing of NESA were ignored. Given the projected price of iron ore at $80 per ton, he suggested that the net present value of the investment project was $83 million (Exhibit 4).

Approach 2 – Accounting Officer

The accounting officer at New Earth suggested that the new investment in South Africa carried substantially higher risks than the typical investments that had been made by the company in the

New Earth Mining, Inc. | 913-548

HARVARD BUSINESS SCHOOL | BRIEFCASES 5

past. He also argued that since New Earth’s major operation had been gold exploration and production it would be inappropriate to use the company’s cost of capital for the new venture. Based on similar investments that were made by peer companies in iron ore development in developing countries the accounting officer proposed to discount the projected cash flows at 24%, a 10% premium above New Earth’s cost of capital. The specifics of the financing package were ignored. Given the new discount rate the project would have a net present value of -$28 million (Exhibit 4).

Approach 3 – External Consulting Firm

New Earth hired an outside consulting firm to provide an independent perspective on the profitability of the new investment. The consulting firm suggested that the NESA investment was a stand-alone project for the company with unique opportunities and leverage properties. On the one hand, the required rate of return on the company’s equity investment in NESA would be higher than the company’s own 14% cost of capital because the new investment carried considerable risks. On the other hand, the substantial leverage taken by New Earth for the new venture could result in lower cost of capital for the subsidiary than the parent company. Therefore, the cost of capital for NESA should be properly estimated and all cash flows from the project would be discounted at this rate. The cost of NESA’s equity was assumed to be 24% given the risks and substantial leverage associated with the project.

Approach 4 – Internal Analyst

A financial analyst working at New Earth suggested that the company compare the discounted cash flows for equity holders at NESA’s cost of equity (24%) to the equity invested by New Earth, known as the Flows to Equity approach. The rationale behind this approach was that New Earth’s relevant investment was $40 million and the cash flows consisted of only the dividends to be paid to equity holders. New Earth would be completely insulated from the threat of losing more than its equity invested in NESA. Based on this approach, a full partitioning of the projected cash flows to debt holders and equity holders had to be estimated. The analyst created the cash flow partition to different providers of capital (Exhibit 7) as well as the schedule of debt amortization with debt prepayment (Exhibit 8). His analysis included a faster retirement of debt principal due to the prepayment covenant.

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New Earth Mining, Inc. | 913-548

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Exhibit 2 Iron Ore Spot Price CFR China (62% Fe) from 2002 to 2012 (US$/ton)

Source: IndexMundi

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New Earth Mining, Inc. | 913-548

HARVARD BUSINESS SCHOOL | BRIEFCASES 9

Exhibit 4 Sensitivity of NPV (in millions of dollars) to Ore Prices versus Various Discount Rates

Discount rates Iron ore at $80 Iron ore at $100

5% $336.64 $581.42

6% $294.51 $519.25

7% $256.97 $463.80

8% $223.43 $414.23

9% $193.41 $369.81

10% $166.46 $329.90

11% $142.23 $293.97

12% $120.39 $261.56

13% $100.66 $232.24

14% $82.80 $205.68

15% $66.61 $181.57

16% $51.89 $159.63

17% $38.50 $139.63

18% $26.29 $121.36

19% $15.13 $104.66

20% $4.93 $89.34

21% ($4.43) $75.29

22% ($13.01) $62.37

23% ($20.91) $50.46

24% ($28.17) $39.49

25% ($34.87) $29.35

26% ($41.05) $19.97

27% ($46.77) $11.28

28% ($52.05) $3.22

29% ($56.95) ($4.26)

30% ($61.50) ($11.21)

913-548 | New Earth Mining, Inc.

10 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 5 World Top 10 Countries in Iron Production, Consumption, and Steel Production (Million Tons)

World Iron Ore Production by Smelter Location

Country 2005 2006 2007 2008 2009 2010 2011

China 420 588 707 824 880 1,070 1,200 Australia 262 275 299 342 394 433 480 Brazil 280 318 355 355 300 370 390 India 140 140 180 220 245 230 240 Russia 105 110 105 85 100 101 100 Ukraine 73 76 80 56 72 78 80 South Africa 40 40 42 53 55 59 55 US 54 53 52 54 27 50 54 Canada 30 34 33 31 32 37 37 Iran 19 20 32 32 33 28 30 Rest of World 267 246 315 248 262 134 134

World Total 1,690 1,900 2,200 2,300 2,400 2,590 2,800

World Iron Ore Consumption

Country 2005 2006 2007 2008 2009 2010 2011

China 524 649 746 750 865 937 1,005 Japan 133 135 139 138 107 132 130 Russia 77 82 82 77 68 77 77 South Korea 44 44 47 50 44 53 68 India 41 44 46 48 46 62 62 Brazil 54 52 57 56 41 51 53 US 58 61 57 55 31 44 48 Ukraine 58 61 57 50 41 44 46 Germany 46 49 50 47 32 47 44 Taiwan 16 16 17 15 13 15 21 Rest of World 195 195 206 197 142 179 175

World Total 1,246 1,388 1,504 1,483 1,430 1,641 1,729

World Steel Production by Smelter Location

Country 2005 2006 2007 2008 2009 2010 2011

China 348 421 488 499 567 626 684 Japan 112 116 120 119 88 110 108 US 93 99 97 91 58 81 86 India 39 43 50 55 58 66 72 Russia 65 70 72 68 59 67 69 South Korea 48 49 51 53 48 58 68 Germany 45 47 49 46 33 44 44 Ukraine 39 41 43 37 30 33 35 Brazil 32 31 34 34 27 33 35 Turkey 21 23 25 26 25 29 34 Rest of World 263 276 286 276 204 247 256

World Total 1,105 1,216 1,315 1,304 1,197 1,394 1,491

Sources: US Geological Survey and Bloomberg

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