Capital Structure Analysis of Rio Tinto

Rio Tinto is one among the companies engaged in mineral and metal mining industry and is regarded as one of the world’s largest conglomerate, the chief mined commodities being copper, aluminium, iron ore, uranium, coal and diamonds. The company has dual head offices in UK and Australia (Rio Tinto, 2018a). The company operates in the UK as Rio Tinto plc, the shares of which are listed at the London Stock exchange where it is a part of the FTSE 100 Index, and as Rio Tinto Limited in Australia, the shares of which are traded at the Australian Securities Exchange. The capital structure analysis of the company Rio Tinto is as follows.

The number of the ordinary total issued and the paid-up shares on the 31^st December 2017, the company Rio Tinto plc were 1351.609 million (Rio Tinto, 2018b). The amount of share capital as on that date was US $ 220 million. Out of which the shares held by the public are 1342.058 million and the shares held in the treasury are 9.551 million (Rio Tinto, 2018b). There are three other classes of the shares i.e. firstly the Special Voting Right Share, DLC Dividend Share, and Equalisation Share. A brief analysis of the various types of the consolidated reserves and the retained earnings of the company is as follows. There are five categories of the reserves namely the capital redemption reserve, foreign currency translation reserve, hedging reserves, sale revaluation reserves, and the cumulative other reserves. The balance in the Capital redemption reserve as on 31^st December 2017 was US $ 38 million. The balance in the Hedging reserves as at the end of the financial year 2017 was US $ 32 million and the balance of the sale revaluation reserves after all the adjustments was US $ 20 million. The balances of the Foreign currency translation reserve and the cumulative other reserves were US $ 480 million and US $ 11714 million respectively. The retained earnings amounted to US $ 23761 million. The total borrowings and the other financial liabilities out of the non-current liabilities amounted to US $ 15148 million.

The net debt amounts to 2869 Pound Sterling or US $ 3845 million or US $ 3.8 billion and the total equity amounted to US $ 51115 million (Rio Tinto, 2018). And therefore the net gearing or the net debt to the total capital accounts for about 7 percent, as on the year ended on 31^st December 2017 (Rio Tinto, 2018). The net gearing has been calculated using the following formula.

Net Gearing =

Which implies, net gearing of Rio Tinto (in US $ million) = 3845/ 51115 = 7 %

The net gearing has improved from the last year which was 17 percent. The net debt has decreased from US $ 9.6 billion in the year 2016 that accounts for the decrease of about 60 percent. The major reason being, operating cash inflows and the proceeds from the disinvestment activities were offset by the cash returns to the shareholders and the capital expenditure activities. The interest cover for the year 2017 was 14 times as compared to 7 times of the last year. (Rio Tinto, 2018). The decrease in the net debt and the improvement in the interest cover are strong indicators in the balance sheet of Rio Tinto. Borrowings and other financial liabilities are initially recognised by the company at fair value, i.e. net of transaction costs incurred by the entity. The same are later on measured at the amortised cost. The total short terms borrowings and bank overdrafts amounted to US $ 552 million. The medium and long-term borrowings amounted to US $ 14624 million. The cash and cash equivalents at the yearend stood at US $ 10550 million. As per the group cash flow statement, the repayment of the borrowings during the year amounted to US $ 2795 million.  The cash and cash equivalents as on 31^st December 2017 were US $ 10550 million.

Sources of Financing Used by Rio Tinto

The five major techniques of evaluation of the capital appraisal projects are described below, i.e. NPV method, profitability index method, internal rate of return method, accounting rate of return method and payback period method.

Net Present Value (NPV)

The method uses the important concept of the time value of money. The cash flows arising out of the operations over the years are first discounted and then in the next step, these are compared with the initial capital investment amount. In order to determine the NPV, the following formula is used (Brigham and Houston, 2012).

NPV=

=  +  +  + …. +

where:

CF_i = net cash flow from year i,

CF₀ = initial investment,

k = discount rate, and

n = number of years.

The few of the benefits of the method of investment appraisal are consideration of an important comncept of finance i.e. the time value of money, consideration of both pre and the post-project cash flows and taking into account the risks associated with each of the projects while comparing more than one projects. (Gallo, 2014). The weaknesses are that the method is complicated, it is complicated to compute a suitable discount rate and the results may not be useful in case of comparison of the projects with unequal lives.

Profitability Index Method (PI)

 This technique of capital appraisal measures the ratio between the amount of the initial investment and the cash flows occurring later on. And therefore, the formula for PI is as follows-

Profitability Index =

The capital appraisal method is helpful when the initial capital investment is of a limited amount (R?hrich, 2014). The similarity of the method with that of the NPV method refers to similar advantages. The weakness of the technique it doesn’t lead to an appropriate capital rationing in case of the indivisible projects.

Internal Rate of Return Method (IRR)

 The IRR method is similar to the NPV method. The internal rate of return represents the interest earned by the entity on the capital employed at various points of time in relation to the investment proposal concerned (Arjunan, 2017). IRR can be determined by using the following formula:

IRR=  + ,

Where d_l = lower discount rate and

d_h = higher discount rate.

The key benefit of the technique is that the method considers the time value of the money. The major disadvantages are that the method works on the reinvestment assumption that the intermediate cash flows arising are invested at the same rate as that of the IRR.

Accounting Rate of Return Method (ARR) 

The calculation of the ARR is done in two steps. Firstly, by dividing the expected net operating profits of the organisation by the initial investment. Secondly, the result of the above calculation is then compared with the top management’s pre-decided rate of return. Accordingly, a capital appraisal project is accepted or rejected (Corporate Finance Institute, 2018). And therefore, the ARR can be calculated by using the below mentioned formula.

Accounting rate of return =

The benefit of this method is the simplicity to perform and the consideration of the accounting profits unlike in the other methods (Scott, 2012). The weakness is avoidance of the time value of money and the results are described in the ratio form instead of the actual profits; as a result, information can be misinterpreted.

Net Gearing Ratio and Interest Cover

Pay Back Period Method

The time in which the cash inflows of any proposal becomes equal to the initial capital investment of the project is the payback period (Prakken, 2012). The formula for payback period is as follows.

Payback period =  Cost of the project/ Annual cash inflows

The advantages of this capital appraisal technique are that it is easy to understand and the liquidity is considered. The major disadvantage is non-consideration of the time value of money (Lane and Rosewall, 2015).

The company Rio Tinto recognises the importance of the capital expenditure and how it is necessary to sustain the productive capacities of the already installed asset base for the growth and the development. The company states that it follows a rigorous investment process that involves prudent assessment practices and the same are selected only if attractive returns are offered over and above the cost of capital. The company’s total capital expenditure during the year 2017 was US$4.5 billion. The major capital project in the year 2017 was the development of underground copper mine of Oyu Tolgoi and the construction of infrastructure at Amrun bauxite project (Rio Tinto, 2018).

Conclusion

As per the analysis in the previous sections, following conclusions can be established that the capital structure, sources of finance, types of reserves, nature of borrowings are important components of the balance sheet of the entity. In addition to these, there are various methods of capital appraisal used by the entities before entering into a capital expenditure contract, to assess the viability of the same. Each of the methods has its own share of pros and cons. As discussed, Rio Tinto’s overall capital is divided into two major heads as Rio Tinto plc and Rio Tinto Limited. There are various kinds of reserves along with varied sources of finance. The capital structure has improved as that from the last year as depicted by the gearing ratio. In addition, the company has considered few major capital investments this year for the overall development and growth of the entity.

References

Arjunan, K. C. (2017). A New Method to Estimate NPV from the Capital Amortization Schedule and an Insight into Why NPV Is Not the Appropriate Criterion for Capital Investment Decision. Retrieved from: file:///C:/Users/System04100/Downloads/SSRN-id2899648.pdf

Brigham, E. F., and Houston, J. F. (2012). Fundamentals of Financial Management. Boston MA: Cengage Learning. 

Corporate Finance Institute (2018). ARR- Accounting Rate of Return. Retrieved from: https://corporatefinanceinstitute.com/resources/knowledge/accounting/arr-accounting-rate-of-return/

Gallo, A. (2014). A refresher on net present value. Harvard Business Review. Retrieved from: https://www.cogencygroup.ca/uploads/5/4/8/7/54873895/harvard_business_review-a_refresher_on_net_present_value_november_19_2014.pdf  

Lane, K., and Rosewall, T. (2015). Firms’ investment decisions and interest rates. Reserve Bank of Australia Bulletin. June quarter. Retrieved from: https://www.rba.gov.au/publications/bulletin/2015/jun/pdf/bu-0615-1.pdf

Prakken, B. (2012). Information, Organization and Information Systems Design: An Integrated Approach to Information Problems. New York: Springer Science and Business Media.

Rio Tinto. (2018a). Corporate Governance. Retrieved from: https://www.riotinto.com/aboutus/corporate-governance-22039.aspx

Rio Tinto. (2018b). Annual Report 2017. Retrieved from: https://www.riotinto.com/documents/RT_2017_Annual_Report.pdf

R?hrich, M. (2014). Fundamentals of Investment Appraisal: An Illustration based on a Case Study. Boston: Walter de Gruyter GmbH & Co.

Scott, P. (2012). Accounting for Business: An Integrated Print and Online Solution. Oxford: Oxford University Press. 342.