Mining companies are currently generating large amounts of cash due to the high commodity prices that have resulted from increased demand from China and India as well as from increased production volumes following investment in additional capacity in recent years. Cash levels have increased further from the cash generated from asset sales as a result of recent restructures. Cash generation levels are expected to remain high for the foreseeable future which has given rise to the enviable problem for mining companies of what to do with the surplus cash.
Surplus cash represents a problem due to the resulting impact on capital structure. Every company has a target capital structure which is determined based on a number of factors including the riskiness of the underlying business operations, tax position of the company in terms of its ability to avail of tax deductions on interest payments, requirement for financial flexibility, as well as attitude to different forms of finance. Surplus cash reduces gearing below the target range which gives rise to lower returns on equity. Conversely, higher gearing can threaten a company’s credit rating and increase the cost of debt finance.
Mining companies have responded to the problem of surplus cash by spending the cash (on acquisitions or by accelerating organic growth) or by returning cash to shareholders (through special dividends or share buybacks). Each of these approaches is not without its risks.
There has been extensive M&A activity in the mining sector which reflects companies spending surplus cash on acquisitions. However, a cash acquisition at a time of high share prices runs the risk of overpaying in the event that commodity prices are not maintained at current levels. Adopting this strategy may depend on a view as to whether we are currently at the top of a cycle or have entered a super cycle.
Organic growth can be accelerated by bringing forward planned projects. This approach depends on the availability of projects at appropriate stages of development as well as expectations regarding the sustainability of future demand. It is also limited due to external factors such as the availability of equipment and outside contractors which are in demand at times of high commodity prices.
Billions of dollars have been returned to shareholders in recent times through special dividends and share buybacks. Buybacks are favored by some market participants who see them as a sign of confidence in the company. However, others view buybacks as a failure to identify opportunities which can earn a return above that which shareholders can earn elsewhere. The relative tax treatments and a requirement for flexibility may also influence the appropriate approach to adopt in returning cash to shareholders. Again, the view of the company regarding future prospects for the company and the industry is a factor to be considered in returning cash to shareholders. Care is also required in the communication of the rationale for returning cash to shareholders and the approach adopted.
How PwC can help you
Target capital structures vary from company to company and different solutions are appropriate for different companies in achieving an optimal capital structure. PricewaterhouseCoopers’ Global Mining group includes professionals in the Valuation & Strategy, Corporate Finance, Taxation and Transactions Services divisions who assist clients in this complex area. Specific areas in which we provide advice to global mining clients include:
- Determination of target capital structure and cost of capital
- Identification and analysis of available strategic options
- Project appraisal having regard to cost of capital
- Transactions assistance – valuation, financial, tax and commercial due diligence, lead advisory
- Assessment of alternative options for returning cash to shareholders taking into account factors such as
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- impact on capital structure
- impact on future returns
- market expectations
- tax efficiency
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