Deccan Ceramics: Project-Specific Discount Rate, Customer Concentration and a Phase II Option
Deccan Ceramics Ltd is appraising a greenfield vitrified-tile plant. The CFO's model shows an outlay of ₹258 crore at year 0 - including ₹18 crore for emission-control equipment required by a consent condition - and level free cash flow of ₹59.6 crore in each of years 1 to 8, with no terminal value. At the group WACC of 12% this gives an NPV of ₹38 crore, and the board paper recommends approval on that basis. The plant is to be funded with ₹160 crore of project debt at 9.8% and ₹80 crore of equity, and the CFO has used the group rate rather than a project rate. A listed tile manufacturer with an equity beta of 1.60 and debt/equity of 0.50 is the closest comparable. The risk-free rate is 7.0%, the market risk premium 6.0%, and the tax rate 25.17%. Forty-five per cent of output is committed to one distributor under a four-year agreement that expires before the plant's life ends. Management also holds land and a consent to add a Phase II line for ₹90 crore in year 3.
1. Derive the project-specific WACC and re-compute the NPV. What do you conclude about the board paper?
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Unlever the comparable
βu = 1.60 / [1 + (1 − 0.2517) × 0.50] = 1.60 / 1.3742 = 1.164
Relever at the project's capital structure (D/E = 160/80 = 2.0)
βL = 1.164 × [1 + 0.7483 × 2.0] = 1.164 × 2.4966 = 2.907
Ke = 7.0 + 2.907 × 6.0 = 24.44% Kd (after tax) = 9.8 × 0.7483 = 7.33% WACC = (1/3 × 24.44) + (2/3 × 7.33) = 8.15 + 4.89 = 13.04%
NPV at 13.04%
Annuity factor, 8 years at 13.04% = (1 − 1.1304⁻⁸) / 0.1304 = 4.792
NPV = (59.6 × 4.792) − 258 = 285.6 − 258 = +₹27.6 crore
Conclusion on the board paper. The project still clears its cost of capital, but the margin is ₹27.6 crore, not ₹38 crore - a 10.4% NPV-to-outlay ratio, which is thin for a greenfield plant with a single-machine dependency and a concentrated customer. The board paper overstates the cushion by roughly ₹10 crore because it applies a group rate to a project whose leverage (67% debt) and business risk are both higher than the group's. Two further weaknesses in method: a single constant WACC assumes the 2:1 structure is maintained for eight years, which is untrue for amortising project debt (APV would be more defensible); and the ₹18 crore emission-control spend is non-discretionary, so it belongs in the base case and cannot be treated as an optional add-on.
2. Quantify the exposure to non-renewal of the distributor agreement after year 4, and state the break-even assumption for the project to remain value-neutral at the project WACC.
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Scenario: distributor exits after year 4. Assume free cash flow falls by 40% in years 5 to 8 (45% of output, allowing for partial replacement through other channels).
Discount factors: annuity factor years 1–4 at 13.04% = 2.972; years 1–8 = 4.792; therefore the years 5–8 factor = 1.820.
PV of the fall = 0.40 × 59.6 × 1.820 = ₹43.4 crore NPV becomes 27.6 − 43.4 = −₹15.8 crore
So the entire equity cushion is wiped out by a single foreseeable event: the expiry of a four-year contract on an eight-year asset.
Break-even. The NPV is extinguished by a fall in annual free cash flow of 27.6 / 1.820 = ₹15.2 crore, i.e. 25.4% of ₹59.6 crore, if it occurs in years 5–8. Given that one distributor accounts for 45% of output, a 25% volume loss is well within the plausible range.
Interpretation. The distribution of outcomes is skewed: the base case is a modest positive NPV, while the downside case is negative on a probability that is not remote. For a project of this size, the decision should turn on whether the distributor agreement can be extended or the concentration diversified before financial close; if neither, the base case should carry the 40% haircut in years 5–8 and the project should not proceed on the CFO's numbers.
3. Evaluate the Phase II option and recommend the approval structure the board should adopt.
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The option. The land and consent to build a ₹90 crore Phase II line in year 3 constitute a growth option: management can decide in year 3 with information the market does not have and with the Phase I plant already operating. Standard DCF ignores it because the ₹90 crore is not committed today. Under a real-options framing, Phase II adds value equal to its own NPV at the year-3 decision date multiplied by the probability that it will be exercised, discounted back at the project rate - and it is asymmetric, because a poor Phase I outcome simply means not exercising.
Why it supports staging rather than a yes/no. Key considerations:
- The Phase I NPV of ₹27.6 crore is too thin to absorb a ₹258 crore irreversible outlay with 45% customer concentration. An irreversible commitment should demand a larger cushion.
- The Phase II option has value only if it is genuinely exercisable - the consent must not lapse, and the land must remain unencumbered.
- Option value is destroyed by committing to both phases now.
Recommended approval structure
- Approve Phase I with stage gates: distributor agreement extended or replaced so that no single customer exceeds 30% of output before commissioning; uptime and yield tests at month 6 of operation.
- Record Phase II as a separate investment case to be brought back at the end of year 2 with actual yield, energy cost and price realisation data.
- Re-run the appraisal at 13.04% (not 12%), with the emission-control spend in the base case, and post-audit the assumptions 12 months after commissioning against the original model.
- Disclose the customer concentration and the option as principal risks in the board papers, since they, not the discount rate, drive the decision.