Expansion Decision Under Capital Constraints
Padma Foods Ltd (PFL) has Tk 300 million of available capital and two mutually exclusive expansion options. Option A is a new production line costing Tk 300 million, expected to generate annual free cash flow of Tk 75 million for six years, with a terminal value of Tk 40 million. Option B is a distribution acquisition costing Tk 280 million, expected to generate annual free cash flow of Tk 70 million for five years, with no terminal value. PFL's weighted average cost of capital is 13%. PFL's current debt-to-equity ratio is 0.9 and its bank requires it to stay below 1.0. Option A would be debt-funded, raising the ratio to 1.05; Option B would be funded from cash and retained earnings, keeping the ratio at 0.85. PFL's largest customer accounts for 30% of revenue and has indicated it may insource production within two years. Management favours Option A because its payback is shorter.
1. Evaluate the two options using appropriate investment appraisal and recommend one, addressing the covenant constraint.
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Compute NPV at 13%. Option A: annuity factor for six years at 13% is approximately 3.998, so present value of annual flows is Tk 75m x 3.998 = Tk 299.9m; terminal value Tk 40m discounted six years at 13% (factor about 0.480) is Tk 19.2m; total present value about Tk 319.1m less Tk 300m cost gives NPV of about Tk 19.1m.
Option B: annuity factor for five years at 13% is approximately 3.517, so present value is Tk 70m x 3.517 = Tk 246.2m, less Tk 280m cost gives NPV of about negative Tk 33.8m.
On NPV, Option A is clearly superior. But Option A breaches the debt covenant, raising debt-to-equity to 1.05 against a 1.0 limit. A breach can trigger acceleration and cross-default, so the covenant is a binding constraint, not a footnote. Management's payback argument is a secondary, non-discounted measure and should not override NPV and covenant analysis. The recommendation is to pursue Option A only if the bank grants a waiver or the funding mix is restructured with equity; otherwise Option B destroys value and PFL should consider a smaller phased Option A or deferral.
2. Incorporate the customer concentration risk and recommend how PFL should proceed.
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The 30% customer may insource within two years, which directly threatens the cash flows of both options but especially Option A, whose payback relies on sustained volume over six years. This is a strategic risk that should be reflected in scenario analysis: model a downside where 30% of revenue disappears from year three, recompute NPV for both options, and assess whether Option A still covers its cost of capital. If the downside NPV turns negative, the project's margin of safety is thin.
Recommendation: negotiate a supply agreement or take-or-pay commitment with the customer before committing capital; seek a covenant waiver or equity injection to make Option A fundable; and consider a phased investment that preserves optionality. PFL's board should document the decision, the risk assessment and the covenant position. Professional ethics require presenting the covenant breach and concentration risk to the board honestly rather than favouring management's preferred option.