Project appraisal, the right discount rate and a debt covenant
Kilele Beverages Ltd is appraising a KSh 14,000,000 bottling line with a five-year life, nil residual value and straight-line depreciation. It is expected to add KSh 6,000,000 of revenue a year at a 60% contribution margin and to cut annual operating costs by KSh 1,200,000. A KSh 900,000 feasibility study was completed and expensed last year. The finance director proposes to charge KSh 1,500,000 a year of existing head-office overhead to the project. Tax is 30%, paid in the year the profit arises. The company's current WACC is 13%, based on an equity beta of 0.9, but the line enters a new market segment whose systematic risk corresponds to a beta of 1.6. The risk-free rate is 11% and the market risk premium 6%. The bank covenant limits total debt to 2.5x EBITDA; Kilele carries KSh 40,000,000 of debt and KSh 18,000,000 of EBITDA, and proposes to fund 70% of the line with new debt.
1. Compute the relevant annual incremental after-tax cash flow. Justify the treatment of the feasibility study and the overhead allocation.
Read the worked answer
Incremental EBITDA
- Contribution: 6,000,000 × 60% = 3,600,000
- Operating cost saving: 1,200,000
- Incremental EBITDA = 4,800,000
Operating cash flow
- Depreciation: 14,000,000 ÷ 5 = 2,800,000
- EBIT: 4,800,000 − 2,800,000 = 2,000,000
- Tax at 30%: 600,000
- Annual cash flow = 4,800,000 − 600,000 = KSh 4,200,000 for years 1–5
Financing costs are deliberately excluded - they are captured in the discount rate. Depreciation is not a cash flow but does generate the tax shield above.
The KSh 900,000 feasibility study - exclude. It has already been incurred and expensed. No decision now can change it. Including it would wrongly make an acceptable project look marginal and, worse, would tempt the board to continue a bad project because of money already spent. It may appear in the narrative as "cost already committed" but not in the NPV.
The KSh 1,500,000 overhead allocation - exclude. It is an apportionment of costs that exist whether or not the line is bought. It is not incremental; group cash flow is unchanged. Allocating it improves product costing but destroys the NPV. If, and only if, the project genuinely triggers additional head-office cost (an extra planner, additional warehouse space), that incremental amount is included.
Points to state explicitly:
- No working capital or residual value is given; if inventory and debtor investment were required, they would be a year-0 outflow recovered at the end.
- The cost saving should be tested for realism - a supplier discount that expires would not be a five-year cash flow.
2. Which discount rate should be used, and what does the NPV show on each basis? Advise the board.
Read the worked answer
The rate is the central judgement. 13% is Kilele's existing WACC, built on a beta of 0.9 from a mature beverage business. The new line operates in a different segment with a beta of 1.6 - roughly double the systematic risk. Discounting a higher-risk project at the firm's existing WACC systematically overstates its value, because the required return is too low.
Risk-adjusted (project) rate - CAPM: Ke = 11% + 1.6 × 6% = 20.6%
Annuity factors:
- 5 years at 13%: (1 − 1.13⁻⁵) ÷ 0.13 = 3.5172
- 5 years at 20.6%: (1 − 1.206⁻⁵) ÷ 0.206 = 2.9515
| Basis | Rate | PV of KSh 4,200,000 | NPV |
|---|---|---|---|
| Firm WACC | 13% | 14,772,240 | +772,240 |
| Project rate | 20.6% | 12,396,300 | (1,603,700) |
The decision flips. At the firm's WACC the line looks marginally acceptable; at the rate its risk actually demands it destroys about KSh 1.6m of value.
Advice to the board.
- Reject on the risk-adjusted basis. The margin of safety at 13% is only KSh 772,000 on a KSh 14m outlay - less than 6% - which is within the error of the assumptions.
- Before rejecting outright, test the sensitivities that matter: contribution margin (60% is the single biggest driver), the durability of the cost saving, and whether the 20.6% estimate is itself too harsh. A private segment beta estimated from a small listed comparator can overstate the rate; an alternative is a divisional WACC with Kilele's own gearing re-applied. Even a rate of 17% leaves the project negative, so the conclusion is robust.
- Do not allow the project to be justified by the sunk feasibility study or by "we have already spent the money" - that is precisely the sunk-cost fallacy the study invites.
- If the strategic value (market entry, later expansion options) is asserted, quantify it as a separate real option rather than smuggling it into a lower discount rate.
3. Assess the covenant position and recommend how the funding should be structured.
Read the worked answer
Current position: 40,000,000 ÷ 18,000,000 = 2.22x, comfortably inside the 2.5x cap.
After the new debt: 70% × 14,000,000 = 9,800,000 of new borrowing → total debt 49,800,000.
- Tested against current EBITDA: 49,800,000 ÷ 18,000,000 = 2.77x - breach.
- Tested pro forma with the full-year benefit of the line (EBITDA 18,000,000 + 4,800,000 = 22,800,000): 49,800,000 ÷ 22,800,000 = 2.18x - compliant.
The covenant is therefore breached or satisfied depending on a definition the board may not have read.
What to do before committing.
- Read the covenant clause. Is it tested on a rolling twelve-month historical EBITDA, or on a pro forma basis including the full-year effect of committed capex? Is it tested quarterly, at year end, or only on drawdown? A drawdown-date test on current EBITDA cannot be passed.
- If the historical test applies, obtain a written waiver or consent from the bank before drawing, supported by the projections. Discovering the breach after drawdown converts a technical issue into an event of default and may cross-default other facilities.
- Alternative structures worth pricing:
- Fund part of the line with equity or retained earnings to keep total debt below KSh 45,000,000 (2.5 × 18,000,000).
- Lease the line instead of buying - but check whether the covenant defines debt to include lease liabilities; under IFRS 16 the balance sheet will capitalise it even if the covenant wording has not caught up.
- Stage the investment: buy two of the three lines, prove the demand, and fund the balance from cash flow.
- Note the interaction with the appraisal: the covenant does not make a negative-NPV project acceptable. Even with the covenant resolved, the risk-adjusted NPV above remains negative; the covenant analysis only tells you what you must negotiate if the board decides to proceed on strategic grounds.