Diamond Energy Resources It was December 2015; Mr. Agus Halim, the CEO of PT Diamond Energy Resources Indonesia, had just finished reviewing a preliminary acquisition plan prepared by his consultant. He was excited about the opportunity to expand Diamond's coal mining capacity by acquiring a new mine near East Kalimantan. This acquisition would significantly increase Diamond's verified mineable surface coal reserves, and position it as an important player in the coal export market. However, before doing so, Agus needed to ensure that this investment would create value for the firm. Then he needed to get the green light from his parent firm and convince his local banker to provide the necessary financing. Company Background PT Diamond Energy Resources Indonesia, a wholly owned subsidiary of Australian-based Diamond Energy Inc., was established in 2005 to conduct coal mining business in Indonesia. It owned six mines, mainly in the surrounding areas of Central and East Kalimantan, with a combined 4,700 hectares of coal mining concession area and an estimated 40 million tons of coal reserves. It produced approximately 2 million metric tons of coal per year, 80% of which were medium-grade coals with a calorific value of 6,100 cal/g; the other 20% were low grade, with a calorific value of around 3,700 cal/g. The company operated under strict guidelines, conforming to all health and environmental safety standards. It aimed to continuously improve via quality management systems, minimizing occupational hazards and environmental impact, and saving energy and other resources. Its coal production was mainly sold to domestic and international companies such as Glencore, INCO, and Trafigura. Since its incorporation, the company had enjoyed moderate financial success, with operating margins and return on invested capital averaging 21% and 16% in the last five years, respectively. As seen in Exhibit 2, its sales volume (in tons) increased every year from 2010-2015, even though revenue experienced a decline in 2013 and 2014 due to the decline in coal prices. Compared to other companies in the industry, illustrated in Exhibit 3, Diamond was a very small player. However, its operating margin in 2014 was better than most. The debt-to-capital ratios for the industry players vary widely, from 0% to 148% (due to negative equity in a couple of companies). Diamond's ratio of 44% was lower than all but three companies, and was slightly below the average of 59%. The Coal Industry in Indonesia Coal is an important source of energy used to generate about 41% of the world's electricity and produce 70% of the world's steel. Indonesia is one of the largest producers of coal in the world with coal reserves estimated to last approximately another 83 years if the current rate of production were to continue. While there are many smaller pockets of coal reserves spreading across the islands of Sumatra, Java, Kalimantan, Sulawesi, and Papua, most of the coal reserves in Indonesia are in South Sumatra, East and South Kalimantan. The industry is very fragmented with a few large players such as Adaro Energy and Bumi Resources, and a large number of small miners. Since about 70-80% of the production is exported, Indonesia is now the world's largest exporter of thermal coal, exporting a total of 382 million metric tons in 2014 (see Exhibit 4). A significant amount of its exported thermal coal was of medium to low quality, selling mainly to India and China. While coal-mining companies in Indonesia had generally fared well, the risks, especially to small miners, were not insignificant. The decline in coal prices in the last few years had resulted in the clo- sure of some small producers in Indonesia. (For example, by the end of 2012, nearly 90% of the coal mines in Indonesia's Jambi province had to close.) To stem the declining coal prices, Indonesia's gov- ernment tried to limit total coal production in 2014 to a level about 5% lower than that in 2013. Companies producing more than the approved amount would be sanctioned. This put additional pressure on miners, especially those that used debt extensively. These companies were hoping to cope with declining margins by producing more to recover the cost of their infrastructure, but the government's action made it difficult. At the same time, the government was proposing an increase in coal royalties and imposing a windfall profits tax in case coal prices were to increase dramatically. All these actions further decreased miners' profit margins, especially those of small producers with low-quality coal. In addition, China was trying to ban the import of low-grade coal that would greatly affect the small producers' exports to China. Unlike larger miners who could blend higher- and lower-quality coal to meet the Chinese requirement, small producers didn't have the financial resources to do so. All these risks were compounded by the condemnation by Greenpeace that coal mining was destabilizing the Indonesian economy, diminishing livelihoods, and exacerbating poverty. The Investment Proposal Agus Halim invited his finance manager to discuss the acquisition plan with him. They thought the proposed purchase price of the mine was reasonable. The mine-verified mineable surface reserves were of medium quality, and were estimated at 12 million tons. Agus figured they could easily produce at least one million tons from this mine per year. The finance manager estimated that including the mine purchase price, the capital expenditure needed to get production started would be about US$30 million, with US$15 million outlay immediately after the deal was closed, and another US$15 million a year after. The working capital investment was estimated to be an additional $2.5 million a year starting in 2015. Besides capital costs, there were also coal-mining expenses including employee-related costs, internal and external coal transportation costs, blasting, drilling, and other mining-related costs. Additionally, there were expenses related to ash disposal. The finance manager estimated that operating expenses would total US$25 per ton, and would increase at a rate of 5% per year. To determine if the investment would create value for the firm, the finance manager needed to first esti- mate the weighted cost of capital (WACC) for this investment. WACC is calculated by weighting cost of debt and cost of equity, with the proportion of capital in debt (D/(D+E)) and the proportion of capital in equity (E/(D+E)), respectively. r WACC={(- E D D+E = cost of debt = cost of equity D = value of debt E = value of equity )*(1-T)*m}+{(j E 'D+E' T = corporate tax rate *TE} The finance manager figured he could get the bank to finance $12 million of the capital cost with a 10-year term loan at 14% annual interest rate, completely drawn down in 2015. The other $18 million plus $2.5 mil- lion working capital investment would come from cash in hand and equity injection from the parent firm. To estimate the cost of equity, also called the required rate of return for the owners, the finance manager believed the best way was to use the Capital Asset Pricing Model (CAPM). CAPM stipulates that the required rate of return for the equity holders for this investment varies in direct proportion with the systematic risk called beta (B). r = R + B(R e m r = cost of equity e R) Rf = current government benchmark interest rate B = beta of the investment e R-R = equity risk premium m The beta for coal mining companies was estimated to be 1.4, and the equity risk premium for projects in Indonesia was 8.8%. The most recent government benchmark interest rate was 7.5% (see Exhibit 5). The In- donesian stock market performance, the Indonesian rupiah and U.S. dollar exchange rates, and the Indonesian inflation rates are presented in Exhibits 6, 7, and 8, respectively. The finance manager also prepared the cash flow forecasts for this investment based on the prevailing Indonesia corporate tax rate of 25%, shown in Exhibit 9. How attractive was this investment? With the recent coal prices dropped to a level lower than those dur- ing the global financial crisis, do you think it is a good time to pursue expansion of coal mining? Would Agus Halim be able to get the green light from the parent firm to pursue it? Would the bankers grant the $12 million term loan for this acquisition? US Dollars per Metric Ton 130.62 112.65 94.68 76.71 58.74 40.77 22.8 Nov-1985 Nov-1987 Nov-1989 Nov-1991 Nov-1993 Nov-1995 Nov-1997 148.59 Nov-1999 166.56 184.53 202.5 Description: Coal, Australian thermal coal, 12000- btu/pound, less than 1% sulfur, 14% ash, FOB Newcastle/Port Kembla, US Dollars per Metric Ton Unit: US Dollars per Metric Ton Source: Index Mundi, http://www.indexmundi.com/commodities/?commodity=coal-australian&months=360. Nov-2001 Nov-2003 Nov-2005 lian prices. Exhibit 1. Australian Thermal Coal Prices from November 1995 to October 2015. Note: Indonesian thermal coal has lower quality and was selling for slightly less, but tracks the Austra- Nov-2007 Nov-2009 Nov-2011 Nov-2013 Exhibit 2. Financial Highlights, PT Diamond Energy Resources Indonesia (in thousands of US$ unless otherwise stated) Financial Performance Sales Volume ('000s of tons) Net Revenue Operating Income 2010 2011 2012 2013 2014 1,560 1,667 1,805 1,910 1,995 100,476 139,336 142,335 119,968 118,032 23,585 39,526 31,970 19,684 17,536 Net Income Total Assets 9,131 19,291 14,647 8,363 6,532 154,138 195,138 230,759 230,897 221,172 Total Liabilities 92,476 122,024 140,231 133,593 119,710 Shareholders' Equity 61,662 73,114 90,528 97,303 101,462 Total Debt 65,876 87,103 101,172 91,903 78,455 Cash and Cash Equivalents 20,931 19,276 17,241 23,483 25,690 Net Debt 44,945 67,828 83,931 68,421 52,766 Financial Ratios Operating Margin (%) 23% 28% 22% 16% 15% Return on Equity (%) 15% 26% 16% 9% 6% Return on Assets (%) 6% 10% 6% 4% 3% Return of Invested Capital (%) 18% 25% 17% 10% 10% Debt to Total Assets (%) 43% 45% 44% 40% 35% Net Debt to Total Assets (%) 29% 35% 36% 30% 24% Debt to Total Capital 52% 54% 53% 49% 44% Exhibit 3. Financial Highlights of Selected Indonesian Coal Mining Companies, 2014 Revenue Operating Income Company (US$m) (US$m) Operating Income Margin Debt to Total Capital PT Diamond Energy Resources Indonesia 118 18 15% 44% PT Adaro Energy 3,325 388.0 12% 49% PT Atlas Resources 35 (34.6) -99% 53% Pt Berau Coal Energy 1,633 182.6 11% 104% PT Bumi Resources 2,786 (1,686.6) -61% 148% PT Darma Henwa 269 10.9 4% 19% PT Delta Dunia Makmur PT Indo Tambangraya Megah PT Petrosea PT Tambang Batubara Bukit Asam 659 93.7 14% 88% 1,930 187.6 10% 0% 288 20.8 7% 48% 1,160 188.0 16% 18.9% Note: Companies with debt to total capital greater than 100% had negative equity in 2014. Source: FT.com. Exhibit 4. Indonesia's Coal Production and Export from 2007-2014. 2007 2008 2009 2010 2011 2012 2013 2014 Production 217 240 254 275 353 412 474 458 Export 163 191 198 210 287 345 402 382 Domestic 61 49 56 65 66 67 72 76 in million tons Source: http://www.indonesia-investments.com/doing-business/commodities/coal/item236. Exhibit 5: Indonesia Central Bank's Benchmark Interest Rates 2006 2008 2010 2012 2014 Source: Trading Economics (http://www.tradingeconomics.com/indonesia/interest-rate). 14 12 10 8 Exhibit 6: Indonesian Stock Market (JCI) Performance, 1998 to November 2015. JAKARTA COMPOSITE 1998 2002 2006 + 2010 2014 Source: Trading Economics (http://www.tradingeconomics.com/indonesia/stock-market). 5500 4400 3300 2200 1100 0 Exhibit 7. Exchange Rates (Indonesian rupiah per US$) from January 1, 2011-November 1, 2015. 15,000.0 14,000.0 13,000.0- 12,000.0 11,000.0 10,000.0 9,000.00 8,000.00 Jan 1, 2011 Jan 1, 2012 Jan 1, 2013 Jan 1, 2014 Jan 1, 2015 Source: Oanda Historical Exchange Rates. Exhibit 8a. Historical Inflation Rates in Indonesia 2006 2008 20 15 10 5 0 2010 2012 2014 2016 Source: www.tradingeconomics.com; Statistics Indonesia. Exhibit 8b. Inflation Rates in Indonesia in 2015 8.36 6.96 7.26 7.26 7.15 7.18 6.79 6.83 6.38 6.29 Jan 2015 Apr 2015 Source: www.tradingeconomics.com; Statistics Indonesia. 8.5 8 00 7.5 7 6.25 6.5 6 Jul 2015 Oct 2015 5.5 4.89 5 4.5 Exhibit 9. Cash Flow Forecasts for the Proposed Investment Projected Financials of Coal Mining Expansion Proposal (in thousands of US$ unless stated) Forecasted Coal Prices and Volumes 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Coal Price (US$/ton) 45 45 45 50 50 50 50 60 60 60 60 60 Operating Expenses (US$/ton)-5% increase 25 26 28 29 30 32 34 35 37 39 41 43 New Mine Production (thousands of tons) 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Projected Revenue and Costs Projected Revenue Royalties (13.5%) Operating Expenses Depreciation (US$30m/10 years) Pre-tax Operating Profit Taxes (25%) After-tax Operating Profit Projected Non-Operating Cash Flows Capital Costs Working Capital Investment 45,000 50,000 50,000 50,000 50,000 60,000 60,000 60,000 60,000 60,000 (3,000) (6,075) (6,750) (27,563) (28,941) (3,000) (3,000) (6,750) (6,750) (30,388) (31,907) (3,000) (6,750) (33,502) (35,178) (8,100) (8,100) (8,100) (8,100) (8,100) (36,936) (38,783) (40,722) (42,758) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) 8,363 11,309 9,862 8,343 6,748 13,722 11,964 10,117 8,178 6,142 (2,091) (2,827) (2,466) (2,086) (1,687) (3,431) (2,991) (2,529) (2,044) (1,535) 6,272 8,482 7,397 6,257 5,061 10,292 8,973 7,588 6,133 4,606 (15,000) (15,000) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500)