Risk-adjusted cost of capital for a solar project at Tana Power Ltd
Tana Power Ltd is an all-equity electricity distributor with an equity beta of 1.10. It is considering a KES 1.4 billion investment in a solar generation plant, a business quite different from distribution. A listed solar operator has an equity beta of 1.90 and a debt-to-equity ratio of 1:2 at market values. Tana intends to finance the solar project with 40% debt and 60% equity at market values; the pre-tax cost of debt is 12%. The risk-free rate is 9%, the market risk premium is 7% and the corporate tax rate is 30%. The solar project's expected internal rate of return is 17%. Management intends to appraise the project at the company's existing cost of capital, arguing that 'shareholders expect one return from the company, not a different one for each project'.
1. Compute the company's existing cost of capital and the risk-adjusted cost of capital for the solar project, explaining why the two differ.
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Step 1 - company's existing cost of capital (all equity). Ke = 9% + 1.10 x 7% = 16.7%, and with no debt WACC = 16.7%.
Step 2 - ungear the solar comparable. D/E = 1:2 = 0.5 Bu = Be / [1 + (1 - t)(D/E)] = 1.90 / [1 + 0.70 x 0.5] = 1.90 / 1.35 = 1.4074
Step 3 - regear at Tana's project gearing (D/E = 40/60 = 0.6667). Be = 1.4074 x [1 + 0.70 x 0.6667] = 1.4074 x 1.4667 = 2.0642 Ke = 9% + 2.0642 x 7% = 23.45%
Step 4 - WACC. Kd after tax = 12% x 0.70 = 8.4% WACC = (0.60 x 23.45%) + (0.40 x 8.4%) = 14.07% + 3.36% = 17.43%
Why they differ. Beta measures systematic risk. Tana's 1.10 reflects regulated electricity distribution - stable, low-beta cash flows. Solar generation carries construction, resource and offtake risk and the comparable's unlevered beta is 1.4074. Using the company's 16.7% would systematically accept high-risk projects (they look good against too low a hurdle) and reject low-risk ones, transferring wealth from shareholders to the riskiest ventures. Gearing also differs: the marginal WACC must reflect the financing actually used for the project.
2. Recommend whether the project should proceed and identify the factors that could overturn your recommendation.
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Recommendation: reject on the risk-adjusted basis.
- IRR 17.00% versus risk-adjusted WACC 17.43%: IRR is below the hurdle, so NPV at 17.43% is negative.
- Using the company WACC of 16.7% would wrongly show acceptance - that is precisely the error management proposes.
- The margin is only 0.43 percentage points, so the conclusion is thin, not emphatic. Quantify how little it takes to flip: on a 1.4 billion outlay, each 0.43% of discount rate is roughly 6 million a year of value over the asset life; a one-point fall in the risk-free rate or market risk premium would move the WACC below the IRR.
Factors that could overturn the decision:
- Comparable quality. If the listed solar operator is not truly comparable (different technology, merchant versus contracted sales), the regeared beta of 2.06 is unreliable and a range of betas should be tested.
- Financing structure. If the debt is non-recourse project finance, Tana's group gearing does not change and regearing at 40/60 overstates the financial risk borne by shareholders.
- Contractual risk transfer. A long-term power purchase agreement with a creditworthy offtaker would lower operating leverage and justify a lower beta.
- Real options. Staged construction, the option to expand, or the strategic value of entering renewables may make NPV understate value; these should be valued explicitly, not waved through.
- Estimate quality of the 17% IRR - it is a single point estimate and likely carries optimism bias; test the downside.
Judgement expected: state the decision and its margin honestly, recommend the beta range be tested and the financing structure confirmed, and only then commit. Accepting because 'shareholders expect one return' confuses the return shareholders require with the risk of the assets the money is put into.