Part -1:

RESEARCH PROJECT - FINANCIAL MANAGEMENT POLICY DETERMINATION AND STRATEGIC DECISION-MAKING FOR FORTESCUE METALS GROUP LIMITED

Your investment banking firm has been contracted by Fortescue Metals Group Limited (ASX Code: FMG) to provide an independent assessment of their current financial management policy selection and decision-making, and a recommendation regarding the optimal capital budget for the company for the 2015 financial year and incorporation of this capital budget decision-making within the existing financial management policies of Fortescue Metals Group Limited. The focus of this task should be on using information sources, such as the 2015 Annual Report, prior year annual reports and other relevant documentation, to identify and explain the financial management policies adopted by Fortescue Metals Group Limited. The final component of your project should be an investment evaluation application and the provision of strategic advice regarding the implementation and funding of the recommended capital budget in the context of the current financial management policy settings of Fortescue Metals Group Limited.

The detailed overall summary, structural and performance information can be obtained from the 2015 Annual Report document for Fortescue Metals Group Limited. This annual report and prior year annual report documents can also be obtained from the Fortescue Metals Group Limited web-site (www.fmgl.com.au) or from the DatAnalysis Premium database available through the Databases link on the University Library web-site. Other relevant financial information relating to Fortescue Metals Group Limited or the wider corporate sector is as follows:

- Assume that this analysis is being undertaken at July 1st 2015 (the beginning of the 2016 financial year).

- Fortescue Metals Group Limited is a part of the Materials Sector, based on the Global Industry Classification Standards (GICS) Sector Groupings. Fortescue Metals Group Limited's beta coefficient is 0.89, compared to the beta coefficient for the overall Materials industry sector of 1.04.

- The market risk premium is estimated as 3%.

- The Australian dollar to US dollar (AUD/USD) exchange rate on July 1st 2015 was 0.7713.

- Three month LIBOR rate on U.S. dollar was 0.2836% per year on July 1st 2015

- Fortescue Metals Group Limited has a corporate tax rate of 30%.

The required tasks associated with this research project are, based on using the information within the annual report documentation and any other documentation or sources of information considered to be relevant, to identify and outline the following aspects of Fortescue Metals Group Limited's financial management policy:

1) The nature of the firm's working capital management policies. Focus in this determination should be on overall current asset investment and financing policies, rather than the company's adoption of policies relating to specific current asset categories, such as inventories or receivables.

2) Determination of the cost of the various sources of costly (interest-bearing) financing used by the firm and, based on this information, Fortescue Metals Group Limited's overall weighted average cost of capital (WACC).

3) The nature of the firm's earnings distribution and dividend payout policies. This should include discussion of the type of dividend policy employed, whether the firm has an identifiable target dividend policy or payout ratio, changes in dividend payout amounts or patterns, and the consideration of taxation, dividend imputation and franking credit issues and wider elements associated with the firm's overall earnings management and distribution practices.

4) The nature of the firm's capital structure determination policy, including identification of specific policy adoption or usage if relevant, whether the firm appears to have target or optimal capital structure ratios, and the determinants of the firm's capital structure choice.

5) Assuming the following information about different projects of the company, conduct a quantitative assessment of Fortescue Metals Group Limited's capital budget and provide a recommendation of the optimal capital budget for the company for the 2016 financial year and an analytical justification for how the optimal capital budget should be funded and any implications of this for their current financial management policies in place.

Capital Project 1: Development of the Fortescue River Gas Pipeline and Gas Conversion of the Solomon Hub Power Station

- This project is centred on reducing energy costs and carbon emissions by converting the fuel source for the operation of the Solomon Hub Power Station from diesel fuel to natural gas. The project will require the construction of the 270 kilometre Fortescue River Gas Pipeline, which will connect with the existing Dampier to Bunbury Natural Gas Pipeline to provide for delivery of natural gas to the Solomon Hub Power Station.

- The project cost is estimated at $265,000,000.

- Operation of the power station using natural gas rather than diesel fuel is expected provide after-tax savings, not including depreciation deductions, of $20,000,000 per annum.

- Fortescue Metals Group Limited can claim annual straight-line depreciation deductions against the cost of construction of the gas pipeline over a 20-year useful life period.

- The risk classification for this project is: Average Risk.

Capital Project 2: Acquisition of BC Iron Limited

- BC Iron Limited is a listed iron ore development and mining company operating the Nullagine Iron Ore Project in the Pilbara region of Western Australia.

- Based on the $0.30 share price and 196,196,992 shares on issue for BC Iron Limited on July 1st 2015, an expected successful takeover offer price of $0.39 per share.

- Estimated synergies of $16,000,000 in additional annual after-tax net profit are expected immediately following the acquisition, which will grow at 1.80% per annum in the future.

- Deal completion costs are estimated at $5,000,000.

- The risk classification for this project is: Above-Average Risk.

Capital Project 3: Upgrade of the Rail Infrastructure at the Christmas Creek Mine

- Project cost is estimated at $200,000,000.

- Fortescue Metals Group Limited can claim annual straight-line depreciation deductions against the project upgrade cost over a 20-year useful life period.

- The risk classification for this project is: Below-Average Risk.

Capital Project 4: Development of the Western Hub Region which has an indicated resource base of 624 Million tonnes (Mt) of iron ore.

- The project will be developed over a multiple-year period. Annual project development costs are estimated to be $2,200,000,000 during 2016,
$2,600,000,000 during 2017 and $1,600,000,000 during 2018 (the costs are at the beginning of each year).

- The Western Hub Region Project is expected to produce 42 Million tonnes of iron ore each year of its 15-year life, with the first year of iron ore production expected to be at the end of 2018.

- The average iron ore spot market price over the 15-year life of the project is expected to be $85 per tonne.

- Cash operating costs of the mine are estimated at $50.00 per tonne before tax.

- Fortescue Metals Group Limited can claim straight-line depreciation deductions against the cost of construction of the Western Hub Region Project over a 15-year useful life period. Depreciation deductions will be claimed against the operation of the project starting at the end of 2018.

- The risk classification for this project is: Above-Average Risk.

The risk-adjustment criteria employed by Fortescue Metals Group Limited are as follows:

- Below-Average Risk projects: Company WACC

- Average Risk projects: Company WACC

- Above-Average Risk projects: Company WACC

Part - 2:

Additional Details and Information Relating to the Research Project

The research project is an analytical and calculative exercise based around applying subject content and knowledge to the identification of the financial management policies and strategic planning for a major listed Australian company (Fortescue Metals Group Limited)

- There is no specific reason why Fortescue Metals Group Limited (FMG) was chosen, beyond the fact that they operate in a topical and capital intensive industry sector (resources), and provide detailed and informative annual report documents.

Expected learning outcomes from completing the research project:

- An appreciation of the structure and content of annual report documents, and the ability to understand and interpret qualitative and quantitative information presented in annual reports

- The ability to link corporate report and performance attributes with theoretical financial management principles and policies, as a means of identifying corporate decision-making practices

- The ability to critically analyse and evaluate the suitability of specific corporate decision-making and transactions by firms and their potential impact on firm valuation and stockholder wealth

- The ability to develop and present a strategy plan for modifying a firm's investment and financing policies.

Overall, the idea behind this research project is to integrate a number of topics across the subject syllabus, as a means for students to understand the dynamic relationship between the various financial management decisions that firms have to make

- It also represents an example of the sort of work task that a research analyst or consultant might undertake.

Information Sources

All of the requirements of the research project should be able to be completed using the information provided and the 2015 Annual Report document for Fortescue Metals Group Limited, that can be accessed from the subject LMS site

- The major point of the research project is to use information from these documents (such as account items and numbers from financial statements or footnotes, descriptive information from the Chairman's or Directors' reports, or calculations developed using information from the documents) as the means to answer the required questions.

- You may want to refer to annual reports for Fortescue Metals Group Limited from previous years. If so, these are available from the Fortescue Metals Group Limited web-site or from the Morningstar DatAnalysis Premium database, the Bureau van Dijk Mint Global database or the ThomsonOne Investment Banker database, which are all available from the Databases link on the La Trobe University Library web-site (search using the underlined database names).

- You can obtain additional information regarding Fortescue Metals Group Limited from other sources if you think this is useful in answering the questions (it is not necessarily required), but ensure that this information is not used in a verbatim (word-for-word) fashion in the research project without due acknowledgement and that these sources are correctly referenced.

Information on Individual Research Project Requirements

1) The nature of the firm's working capital management policies

The focus here is for you to operationalise the issues that will be discussed in Lecture 9, and use the annual report information to outline (with explanation and justification) the working capital stance (policies) employed by Fortescue Metals Group Limited. This is based on identifying:

- Firstly, their current asset investment policy, which relates to the types of current assets they invest in and the magnitude of current asset investment relative to requirements and the level of current liabilities.

- Such as do they hold large amounts of cash, liquid assets, inventory or other current assets?

- Do they hold large proportions of current assets relative to current liabilities and total assets? Can you classify their current asset investment level as representing a ‘fat cat' or ‘lean-and-mean' strategy, for instance?

- Secondly, their overall working capital (current assets and permanent assets) financing policy, which relates to how Fortescue Metals Group Limited funds their temporary and permanent asset requirements.

- Do they employ a maturity matching, aggressive or conservative working capital policy, and what are the impacts of the observed policy choice? This could be assessed in a range of ways, such as comparing current asset and current liability levels and comparing permanent asset (such as property, plant and equipment) level with long-term financing sources (such as long-term debt and equity). If you want to evaluate this quantitatively, then you might think about calculating relevant liquidity and activity ratios and other indicators such as the firm's cash conversion cycle (CCC).

- Has there been modification to these policies and how might this relate to changes in other firm attributes and performance?

Major sources of information:

- The Consolidate Statement of Financial Position (balance sheet) in the 2015 Annual Report provides an overall picture of Fortescue Metal Group Limited's asset and liability structure (both current and non- current). The notes associated with the different asset and liability items can be reviewed for more specific detail about these items.

- The Consolidated Statement of Cash Flows and the Consolidated Income Statement provide information about the level of borrowing costs (interest expenses) and financing activities, which tells you something about whether financing costs and sources of financing are changing.

2) Determine the cost of the sources of costly-finance employed by Fortescue Metals Group Limited and use this information to determine their weighted average cost of capital (WACC)

This requires you to determine the cost of the various sources of short- and long-term finance that Fortescue Metals Group Limited uses, and to put this information together to calculate the firm's weighted average cost of capital (WACC). This information is readily available in the annual report documentation:

- The 2015 Annual Report document relating to borrowings and financial lease liabilities provides detailed information (including types, amounts and cost) of the various types of interest-bearing or costly sources of debt finance used by the firm.

- Other information is available within the Annual Report and the research project information to determine Fortescue Metals Group Limited's current cost of equity capital.

- Also need to determine the various finance component weightings and correctly incorporate taxation into any WACC calculations that you perform. Before-tax costs are provided in, or can be calculated from.

3) The nature of the firm's earnings distribution and dividend payout policies.

This relates to identifying the dividend policy (to be discussed in Lecture 7) employed by Fortescue Metals Group Limited, and how the use of this policy might be related to other working capital, capital structure or cost of capital decision-making.

- The starting point is to look at relevant information relating to earnings and dividend flows, and using this information to determine Fortescue Metals Group Limited's chosen dividend policy (which you will hopefully be able to classify as one of common dividend policy types - residual, stable, low regular plus extra or constant payout policies)

- Information that you should consider includes the amount of annual dividend payments, the dividend payout ratio associated with dividend payments (the proportion of earnings that they represent), dividend yields (dividend paid / share price) and ongoing trends in these figures. Dividend information should probably be evaluated for a multiple-year period to identify trends in dividend amount payments or dividend payout ratios, and particularly changes in dividend payment trends and how these relate to changes to other key firm indicators and determinants (such as earnings, capital or investment expenditure, leverage levels, share prices). The 2015 Annual Report provides information about their current dividend distributions, and the Dividend information on the company's DatAnalysis Premium database profile page is useful for providing longer-term historical payout information. Company dividend distributions will also likely be discussed in other Annual Report sections such as the Financial Review and Directors' Report.

- In the context of the Australian corporate sector, it is also relevant to consider the dividend franking policy used by the company for its dividends (in association with the dividend imputation taxation system that exists in Australia), and the existence or absence of other components such as dividend re-investment plans, use of share buy-back (re-purchase) programs or the payment of stock dividends.

4) The nature of the firm's capital structure determination policy

This involves you determining the long-term sources of financing (the mix of debt and equity financing) used by Fortescue Metals Group Limited, and whether or not the company determines this mix in a manner consistent with recognised capital structure determination policies (such as the trade-off or pecking order theories of capital structure discussed in Lecture 6).

- Information about the levels of debt and equity that Fortescue Metals Group Limited employs is summarised in the Consolidated Statement of Financial Position (balance sheet), and the notes related to individual balance sheet items will provide more specific details about these financing components. The Cash Flows from Financing Activities section of the Consolidated Statement of Cash Flows of the 2015 Annual Report will tell you about recent movements in financing sources for the company, and looking at historical trends in debt and equity account balances and leverage ratios will inform about the direction of change in, and the mix of, the firm's financing sources. The 2015 Annual Report provides information about the additional reserve financing sources available to Fortescue Metals Group Limited (such as bank and financing facilities), which may have some relevance to possible changes in future financing choices and their overall financing policy.

- It is also useful to look at relationships between the levels of, and changes in, financing components and leverage ratios and changes in operational items, such as profits, dividend payments and investment expenditure, which will inform about factors which influence leverage levels and may help in explaining the underlying capital structure policy chosen.

- It may be relevant to consider the nature of the firm's business activities and what this might imply about their financing policy, or to investigate whether the leverage ratios of Fortescue Metals Group Limited are similar to those of other firms in the same industry.

- It is also potentially relevant to think about taxation, dividend imputation system and global financing market influences on capital structure decision-making.

5) Capital budgeting evaluation and financing plan application

This requires you to conduct an evaluation of the investment (project) alternatives available to Fortescue Metals Group Limited for the 2016 financial year to determine which should be undertaken, and then develop a financing strategy outlining how Fortescue Metals Group Limited should fund their optimal capital budget.

- Requires you first to conduct NPV analysis for each of the project alternatives, including cash flow calculation, individual project risk adjustment, and real options consideration. This will lead to the determination of which projects are feasible, and the required cost of funding them.

- Then you need to develop a financing policy determining how, or if, they should be funded. This should include consideration of a range of aspects, including the size of the financing requirement, the current capital structure and WACC of the company, the company's current financial management policies and how they may be influenced by funding these investment projects (such as the impact on leverage ratios and the WACC, the ability of the firm to maintain its current dividend policy etc.)

- Particular consideration should be given to any potential other capital commitments that the firm has, collateral requirements or impediments, potential funding or capital raising alternatives available, ownership structure and the likely response of shareholders or debtholders.

- The outcome will be a recommended capital budget and a plan outlining the financing mix to be used to fund this capital budget, any required changes to other financial management policies to implement this financing plan (such as variations from the optimal capital budget, changes in dividend or working capital policies), and what this is expected to do to the key corporate indicators such as the firm's WACC, risk levels and the firm's beta coefficient, share price, etc.