Corporate Finance Final Essay

Submitted By Tanzia-Hasan
Words: 3034
Pages: 13

Table of Contents

I. Introduction 2

Company Strategy and Goals 2

Capital Allocation and Investment Appraisal Methodology 2

II. Evaluation of the Investment Appraisal Techniques for BHP Billiton 4

Evaluation of Net present Value (NPV) Method 4

Evaluation of Internal Rate of Return (IRR) Method 6

Recommendations to BHP Billiton Regarding Investment Appraisal Metrics 7

III. References 10

Introduction
BHP Billiton is one of the world’s leading natural resources companies, operating in more than 25 countries. The company’s core operations include mineral exploration and extraction, and has a diverse commodity portfolio spanning iron ore, copper, aluminum, oil and gas. The strength of the company’s financial framework has enabled it to deliver continuous dividend growth, and a total shareholder return of 394%, over the past decade. According to its 2014 Annual Report, BHP Billiton had an average market capitalization of US$ 179bn in 2014 with a total dividend per share of 121 US cents (an increase of 4% over 2013).
Company Strategy and Goals
The company defines its strategy as being focused on owning and operating a portfolio of assets which are diversified in terms of commodity, market, and geography and are large, expandable, cost effective and upstream. However, the company’s overarching strategic objective is to make decisions on capital allocation to maximize shareholder returns.
The principle reason of BHP Billiton’s consistent success in portfolio management of capital projects is because of its strict reliance on a standardized appraisal methodology. The adherence to its unchanged capital management framework has enabled it to continue having a strong balance sheet (with an A-rating on its debt), maintain a lower cost of capital, and enabled a steady growth in its base dividend. BHP Billiton has recently announced that it would be spinning-out some of its metals (aluminum, manganese, nickel, silver and lead) and selected coal assets into a new publically listed company1. It is believed that this is driven by a desire by BHP Billiton to focus on resources in which the company has better quality assets; namely, iron ore, copper, oil and gas. Refocusing the portfolio on these assets would enable the firm to concentrate investment in projects with a higher likelihood of generating satisfactory shareholders returns.

Capital Allocation and Investment Appraisal Methodology
BHP Billiton’s focus on shareholder value has a strong influence on its capital allocation process, where all alternatives are evaluated and compared for their value potential, namely:
Continued investment in the business
Portfolio simplification
Dividends
Share buy-backs
In principle this means that the company may not choose to invest in new projects if its investment criteria are not satisfied. An elaboration on the company’s investment appraisal methodology will be discussed subsequently.
BHP Billiton uses four primary metrics to assess and rank the financial attractiveness of its investment opportunities, these are: Net present Value (NPV), Internal Rate of Return (IRR), Return on Capital (ROC), and Margin Analysis. These metrics are applied to proposed projects, and their sensitivities are evaluated for a range of scenarios (e.g. product prices, inflation). To rank projects, BHP Billiton adopts a policy of optimizing between these four metrics, as it believes that relying on a single metric creates portfolio imbalances over time. BHP Billiton has not published a full list of its investment criteria, though in a recent investor presentation, the company states that it forecasts an IRR of >20% for its current project pipeline with the aim of increasing the capital efficiency of the group. For a company to create shareholder value it must generate a return greater than its cost of capital (WACC), which for BHP Billiton is estimated to be 9%, hence, projects (or in this…