Approach 1

• The first approach is both naïve and fundamentally flawed.

• This approach calls for discounting NESA’s projected cash flows at
New Earth’s corporate cost of capital.
• It does not recognize the specific risks of the investment and is at
odds with the stand-alone principal in capital budgeting.
Approach 2
• The accounting officer’s approach shows some refinement over the naïve
approach.
• At the very least it recognizes that the investment project to be conducted by
NESA was fundamentally different from the main line of business at New
Earth.
• Had NESA not received government-guaranteed debt financing from their
customers, this approach would provide a reasonable approximation.
• Exhibit 4 suggests a net present value of negative $28 million given the
assumed discount rate at 24%.
• Therefore, New Earth would not be interested in investing in South Africa if it
were forced to advance all of the funds for the new project itself.
Approach 3
• The consulting firm recognized the tax benefits of leverage and the cost savings
from government guarantees associated with the specific project.
• Table TN-A shows that the weighted average cost of capital for NESA is 9.42%.
• Exhibit 4 suggests a net present value of approximately $182 million given the
discount rate and ore price at $80 per ton.
• In fact, the fast prepayment of debt presented in Exhibit 7 and Exhibit 8 suggests
that the initially low WACC as a result of high leverage cannot be applied over
the life of the project.
• NESA’s entire outstanding debt would be completely paid off by 2020.
• As a result, the capital structure of NESA would change rapidly in the first six
years of production.
Approach 4
• The valuation approach suggested by the internal analyst is probably the best
of the four.
• From New Earth’s point of view, the value of its equity position in NESA was
equal to the discounted value of future dividends.
• This approach is known as the Flows to Equity (FTE) approach, which implicitly
considers the benefits from leverage and loan guarantees and the effect of
covenants on valuation.
• An NPV of $33 million can be obtained.
• Indeed, the difference in the net present values of the accounting officer’s
estimate and the internal anayst reflects the value created via the design of
the financing package for the project.