Project-Specific Discount Rates and NPV Sensitivity at Halden Renewables
Halden Renewables Ltd is appraising a five-year solar project. The plant costs £4.8 million immediately and needs £600,000 of working capital at the start, recoverable at the end of year 5. Annual incremental cash inflows after operating costs and tax are forecast at £1.6 million for each of the five years, received at year end. The company is financed 60% equity and 40% debt. Its equity beta is 1.2, the risk-free rate is 3.5%, the market risk premium is 6%, and its pre-tax cost of debt is 6%; tax is 25%. The board proposes discounting at the company WACC. The project team notes that the solar division's asset beta is 1.5 because of construction and regulatory risk, whereas the existing business is regulated water distribution. A £150,000 feasibility study has already been paid. The finance director wants a decision this week and argues that 'any positive NPV at our WACC is worth doing'.
1. Calculate the company WACC and the project-specific discount rate, showing the workings.
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Cost of equity (company). Ke = 3.5% + 1.2 x 6% = 10.7%.
Cost of debt (after tax). 6% x (1 - 0.25) = 4.5%.
Company WACC. Weights are 60% equity, 40% debt: WACC = 0.60 x 10.7% + 0.40 x 4.5% = 6.42% + 1.80% = 8.22%.
Project-specific rate. The solar division's asset beta is 1.5, reflecting construction and regulatory risk not present in water distribution: Ke = 3.5% + 1.5 x 6% = 12.5% WACC = 0.60 x 12.5% + 0.40 x 4.5% = 7.50% + 1.80% = 9.30%.
Caveat. The 60:40 weighting assumes the project is financed on the same basis as the group. If it is financed differently, the divisional beta must be regeared to the project's own debt ratio. The asset beta given is already a business-risk measure, so using it with group gearing is acceptable only as an approximation. Note also that the pre-tax cost of debt is used with a tax shield, so the tax rate must reflect the actual deductibility of interest.
2. Calculate NPV at the project-specific rate and the sensitivity of the decision to the annual cash inflow. Comment on the result.
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Annuity factor at 9.30% for 5 years: 1.093^-1 = 0.91491; 1.093^-2 = 0.83707; 1.093^-3 = 0.76575; 1.093^-4 = 0.70060; 1.093^-5 = 0.64098. Sum = 3.8593.
Present values. Annual inflows: £1.6m x 3.8593 = £6.175m. Working capital recovery: £0.6m x 0.64098 = £0.385m. Total PV of inflows = £6.559m. Initial outlay = £4.8m + £0.6m = £5.4m. NPV = £1.159m.
At the company WACC of 8.22%. Annuity factor at 8.22% for 5 years = 3.9697. PV = £1.6m x 3.9697 + £0.6m x 0.67375 = £6.352m + £0.404m = £6.756m. NPV = £1.356m. Using the company rate overstates NPV by about £0.20m and would encourage acceptance of projects that do not cover their risk.
Sensitivity. Required annual inflow for NPV = 0: (£5.4m - £0.385m) / 3.8593 = £1.300m. The inflow can fall by £0.300m, or 18.8%, before the project destroys value. A 18.8% margin is not large for a construction project with regulatory exposure, and the cash flow forecast is a single point estimate, not a range.
Comment. The project is positive but not robust. The decision should not rest on a single NPV; scenario analysis on construction cost, tariffs and delay, and a check on whether the £1.6m is stated before or after working capital movements, are needed.
3. Advise the board on the choice of discount rate and on the treatment of the feasibility study, and state what else should be considered before deciding.
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Rate. The project-specific rate of 9.30% should be used. The company WACC reflects the risk of regulated water distribution; applying it to a riskier solar project would systematically accept projects whose returns do not compensate shareholders for the extra risk, transferring wealth from shareholders to the project. The correct logic is that the discount rate must match the risk of the cash flows being discounted, not the risk of the existing business.
Feasibility study. The £150,000 is sunk. It is not an incremental future cash flow and must be excluded from the NPV. It is not, however, irrelevant to the decision process: the board should ask what it revealed and whether the forecasts have been independently reviewed, since a study that has already been paid for can create pressure to proceed regardless of the numbers.
Other considerations. Construction overrun and liquidated damages; the regulatory regime and tariff indexation over five years; whether 25% tax and any capital allowances are correctly reflected; working capital assumptions (is £600,000 enough if debtors are slow?); terminal value or decommissioning costs; financing side effects and covenants; and real options, such as the ability to phase the plant or expand later. The finance director's statement that 'any positive NPV at our WACC is worth doing' is wrong on two counts: the wrong rate, and the absence of any risk-adjusted hurdle or sensitivity test. A reasonable recommendation is conditional acceptance, subject to independent validation of the £1.6m inflow and a construction-risk review, because the 18.8% margin of safety is thin.