Golden Harbour Terminals: allocating HK$100 million under a hard capital cap
Golden Harbour Terminals operates a container yard in Tsing Yi. The capital expenditure committee has HK$100 million of approved funding for the coming year and four indivisible projects, all evaluated at the company-wide WACC of 8%:
| Project | Cost (HK$m) | NPV at 8% (HK$m) | IRR |
|---|---|---|---|
| A - automated gate system | 45.0 | 9.0 | 14.2% |
| B - second berth crane fleet | 80.0 | 13.0 | 12.8% |
| C - rooftop solar plus battery | 50.0 | 9.9 | 13.9% |
| D - yard resurfacing | 20.0 | 3.4 | 13.1% |
Project C earns a 15-year, government-backed Feed-in Tariff; project B's throughput is tied to the highly cyclical transpacific trade. The terminals division manager is measured on divisional ROI; his division has assets of HK$120 million and profit of HK$18 million, and project C would be booked in his division. Project C's annual net cash inflow is HK$7.0 million. He has told the CFO he will not submit C this year.
1. Determine the optimal project combination under the HK$100 million cap, showing your ranking method and the rejected alternatives.
Read the worked answer
Profitability index first, then whole combinations
PI = (NPV + cost) ÷ cost:
| Project | Cost | NPV | PI |
|---|---|---|---|
| A | 45.0 | 9.0 | 1.200 |
| C | 50.0 | 9.9 | 1.198 |
| D | 20.0 | 3.4 | 1.170 |
| B | 80.0 | 13.0 | 1.163 |
Greedy PI ranking gives A, then C (95.0 of the cap used), then nothing - the remaining HK$5 million cannot fund D. But because projects are indivisible, the ranking must be confirmed against every feasible combination:
| Combination | Spend | Total NPV |
|---|---|---|
| A + C | 95.0 | 18.9 |
| B + D | 100.0 | 16.4 |
| C + D | 70.0 | 13.3 |
| A + D | 65.0 | 12.4 |
| A + B | 125.0 | not feasible |
A + C maximises NPV at HK$18.9 million and leaves HK$5 million unspent. The intuitive but wrong answer is B, the largest single NPV: B consumes 80% of the budget and blocks C.
Two caveats to put to the committee. First, if the HK$100 million cap is soft and HK$25 million can be raised from the parent at close to 8%, A + B delivers HK$22.0 million of NPV and beats A + C by HK$3.1 million - the cap, not the projects, is then the binding constraint. Second, IRR ranks B last even though B has the second-highest NPV; IRR ignores scale and reinvestment, so it should not drive the choice.
2. Explain, with numbers, why the terminals manager will reject project C, and recommend how the performance measure should change.
Read the worked answer
The manager is optimising his own measure, rationally
Current divisional ROI = 18 ÷ 120 = 15.0%. Using project C's HK$7.0 million annual cash inflow and straight-line depreciation over 15 years (50 ÷ 15 = HK$3.33 million):
- Incremental divisional profit = 7.00 − 3.33 = HK$3.67 million
- New ROI = (18 + 3.67) ÷ (120 + 50) = 21.67 ÷ 170 = 12.7%
ROI falls from 15.0% to 12.7%, so the manager's bonus falls if he invests. The project has a positive NPV of HK$9.9 million at 8% and an IRR of 13.9%, comfortably above the WACC - the company gains, the manager loses. This is the classic underinvestment bias of a ratio measure with a growing asset base.
Why residual income alone does not fully fix it. Year 1 residual income = 3.67 − (8% × 50) = 3.67 − 4.00 = −HK$1.33 million. It turns positive as depreciation falls, but a manager on a one-year horizon still rejects. Depreciation method is doing the damage, not the capital charge.
Recommended changes
- Switch the divisional measure from ROI to economic profit (residual income) with a multi-year vesting period, so the later positive years count.
- Use annuity depreciation for appraisal purposes in capital-intensive investments so the residual income is level across the asset's life instead of back-loaded.
- Carve out strategic projects - Feed-in Tariff, safety, regulatory - from the divisional measure and assess them at group level against group WACC.
- Add a cash-based gate: no capex is refused by a divisional head if it clears the group hurdle rate; refusal must be escalated to the CFO with written reasons.
3. Assess whether a single 8% discount rate is appropriate across projects B and C, and quantify the effect on project B.
Read the worked answer
No - one rate across these two projects misprices both
Project C carries a 15-year, government-backed tariff: low revenue risk, long duration, almost a bond. Project B's cash flows depend on transpacific container volumes, which are cyclical, exposed to shipping alliances and to tariff policy. Applying the group WACC of 8% to both under-discounts B and over-discounts C. The correct approach is a project-specific rate reflecting the systematic risk of the cash flows, built from a proxy asset beta if necessary.
Quantified effect on B. With NPV of HK$13.0 million on a cost of HK$80 million over an assumed 10-year life, the level annual cash flow is (80 + 13.0) ÷ 6.710 = HK$13.86 million. Re-discounting at 10%, the 10-year annuity factor is 6.145:
- PV = 13.86 × 6.145 = HK$85.2 million
- NPV = 85.2 − 80.0 = HK$5.2 million
So a 2 percentage point adjustment removes HK$7.8 million - 60% - of B's apparent value. Project B would still be accepted on its own, but it is no longer the near-equal of A + C that the 8% table suggests.
Qualitative factors that could overturn the ranking either way
- Project B may carry a real option on a third berth or on a shipping-alliance contract extension; if so, the static NPV understates it and the option value should be assessed explicitly.
- Project C's tariff is only as firm as the scheme rules; a policy change after year 7 would truncate the annuity.
- Project A is an operating-cost and labour-availability play as much as a return play - gate automation may be necessary to retain a licence or a customer.
- Project D is largely maintenance capital; deferring it may raise future costs and should not be deferred purely on PI.
Recommendation - set project-specific discount rates before the final vote, and present the combination analysis at both the company rate and risk-adjusted rates.