Capital Budgeting with Foreign Exchange and Covenant Constraints
A Philippine manufacturer is considering a P120 million investment in a new production line for export. The project has a 5-year life, no salvage value, and is expected to generate annual after-tax operating cash flows of P35 million at current exchange rates (P56 = USD 1). Sixty percent of revenue is in USD, while 80% of costs are in PHP. The company's WACC is 12%, but the finance director used a 9% rate because the project is 'strategic.' The peso is expected to depreciate by 5% per year against the USD. The company has a debt covenant requiring a minimum interest coverage ratio of 3.0x; the new debt would be P80 million at 8% interest, and current EBIT is P40 million. The CFO wants to proceed because the payback period is under 4 years.
1. Compute the project's NPV using the appropriate discount rate. Should the 9% rate be used?
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The appropriate discount rate is the company's WACC of 12%, unless the project's risk differs from the company's existing operations. There is no evidence that the project is less risky; the 'strategic' label does not justify a lower rate. NPV = -P120 million + P35 million × PVIFA(12%,5). PVIFA(12%,5) = 3.6048, so NPV = -120 + 126.17 = +P6.17 million. Using 9% gives PVIFA(9%,5)=3.8897 and NPV = +P16.14 million, which overstates value. The 9% rate is not appropriate. The NPV is marginal at about 5% of the investment, so small adverse changes in cash flows or the discount rate would make it negative.
2. Assess the impact on the debt covenant. What additional information is needed?
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The new debt is P80 million at 8%, so annual interest is P6.4 million. Current EBIT is P40 million. If there is no other interest, the interest coverage ratio is 40/6.4 = 6.25x, which is above the 3.0x covenant. But the covenant likely applies to total debt and total interest, and existing debt is not given. Also, the project's EBIT is not the same as its after-tax cash flow; depreciation on the P120 million line (P24 million per year over 5 years) must be considered. Assuming a 30% tax rate, after-tax cash flow = EBIT × 0.7 + 24 = 35, so EBIT = 15.7 million. Total EBIT would be 55.7 million, and total interest would be existing interest plus 6.4 million. The covenant test should be run on a pro forma basis under base case and stress case. Additional information needed: existing debt and interest, tax rate, depreciation policy, working capital requirements, and the exact covenant definition (EBIT vs EBITDA).
3. What qualitative factors and risks should the board consider before approving the project?
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The board should consider: (1) foreign exchange exposure: 60% of revenue in USD and 80% of costs in PHP; a 5% annual peso depreciation would increase peso revenues but also affects pricing and competitiveness. A hedging plan is needed. (2) The marginal NPV means the project is sensitive to assumptions; scenario and sensitivity analysis should be required. (3) The payback period of 3.43 years ignores cash flows after payback and the time value of money. (4) The 9% discount rate is a red flag; the finance director's justification is not supported. (5) The covenant impact must be tested under stress. (6) Export market demand, tariffs, competition, and country risk. (7) The company's capacity to manage the new line. The board should not approve based on payback alone.