Chisomo Processing: NPV, financing and sensitivity
Chisomo Processing plc is evaluating a five-year plant. The plant costs MWK 900m immediately and has no salvage value. Sales volume is expected to be 100,000 units per year. Year 1 selling price is MWK 8,000 per unit and variable cost is MWK 4,500 per unit. Fixed cash costs are MWK 120m in year 1. Prices and costs are expected to rise with inflation of 8% per year; volume will remain constant. The company pays tax at 30% in the same year as the taxable profit arises. Capital allowances are 25% reducing balance, with a balancing allowance in year 5. Working capital equal to 10% of annual revenue is required at the start of each year and is recovered at the end of year 5. The nominal after-tax discount rate is 18%. Chisomo plans to finance 60% by debt at 22% pre-tax and 40% by equity; the required equity return is 24%.
1. Compute the project NPV using nominal cash flows. State clearly how you treat inflation, tax, capital allowances and working capital.
Read the worked answer
Use nominal cash flows because the discount rate is nominal. Year 1 revenue = 100,000 x 8,000 = MWK 800m; variable cost = 100,000 x 4,500 = MWK 450m; fixed cost = MWK 120m; EBITDA = MWK 230m. Inflate revenue and costs by 8% each year, but keep volume constant.
EBITDA: y1 230.0; y2 248.4; y3 268.3; y4 289.7; y5 312.9.
Capital allowances: y1 225.0; y2 168.8; y3 126.6; y4 94.9; y5 balancing 284.8. Taxable profit = EBITDA - capital allowance; tax at 30%: y1 1.5; y2 23.9; y3 42.5; y4 58.4; y5 8.4.
Working capital is 10% of revenue: 80.0 at t0, then increases of 6.4, 6.9, 7.5 and 8.1 in years 1-4; 108.8 is recovered in year 5.
Project cash flows: t0 = -900 - 80 = -980.0; y1 = 222.1; y2 = 217.6; y3 = 218.3; y4 = 223.2; y5 = 312.9 - 8.4 + 108.8 = 413.3.
Discounting at 18% gives a present value of about MWK 773.1m. NPV = 773.1 - 980 = -MWK 206.9m. The project destroys value on these assumptions.
2. Evaluate the financing plan and explain why interest should not be deducted in the project cash flows. Compute the WACC and advise whether the 18% rate is appropriate.
Read the worked answer
Interest should not be deducted in the project cash flows because financing is reflected in the discount rate. Deducting interest as a cash flow and then discounting at a rate that already includes the cost of debt would double-count financing. The tax shield from debt is captured through the after-tax cost of debt in the WACC.
WACC = 60% x 22% x (1 - 30%) + 40% x 24% = 9.24% + 9.60% = 18.84%.
The plan's WACC is slightly above the 18% rate used. Using 18.84% would reduce NPV a little further. The 18% rate is acceptable only if it reflects the project's risk and the target capital structure. If the project is riskier than the company's existing operations, a higher rate is needed. The negative NPV is not caused by the financing mix; the project's operating cash flows are insufficient. The board should not proceed merely because 60% debt financing is available.
3. Calculate the sensitivity of NPV to a change in selling price and to initial cost. Recommend whether to proceed.
Read the worked answer
NPV is -MWK 206.9m. To break even, the present value of after-tax operating cash flows must rise by 206.9m. Using the five-year annuity factor at 18% of about 3.127, the required annual after-tax increase is 206.9 / 3.127 = MWK 66.2m. The pre-tax EBITDA increase is 66.2 / (1 - 30%) = MWK 94.6m.
Per unit, that is 94.6m / 100,000 = MWK 946 per unit. As a percentage of the year 1 price of MWK 8,000, the required price increase is 11.8%. A price increase of about 12% would make the NPV approximately zero.
For initial cost, the required fall is 206.9 / 900 = 23.0%. The plant cost would need to fall to about MWK 693m, or other terms would need to improve, before the project breaks even.
Recommendation: reject the project as presented. It is sensitive to price and capital cost, and the margin of safety is negative. Proceed only if there is credible evidence of at least a 12% price premium, a 23% capital cost reduction, or equivalent cost savings.