WACC and Investment Appraisal Under Currency Risk
Kestrel Engineering plc is evaluating a Rs 600 million expansion into a new export market. The project has a five-year life and is expected to generate annual free cash flows of Rs 150 million in nominal terms. Kestrel's existing capital structure is 60% equity and 40% debt (market values). The risk-free rate is 5%, the equity risk premium is 6%, and Kestrel's equity beta is 1.2. Debt carries a pre-tax cost of 8% and the corporate tax rate is 25%. The new market is considered 30% riskier than Kestrel's existing operations. The project will be funded by a ring-fenced subsidiary in a country with a 15% tax rate and a 12% withholding tax on repatriated dividends. The CFO wants to use the group WACC of 9.8% to appraise the project.
1. Calculate Kestrel's group WACC and explain why it is or is not appropriate for appraising the export project.
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Group WACC calculation:
- Cost of equity (CAPM): Ke = Rf + β × ERP = 5% + 1.2 × 6% = 12.2%
- After-tax cost of debt: Kd = 8% × (1 − 0.25) = 6.0%
- WACC = (0.60 × 12.2%) + (0.40 × 6.0%) = 7.32% + 2.40% = 9.72% (≈ 9.8% as the CFO states)
Is it appropriate? No.
- Different risk profile – the new market is 30% riskier. A project-specific discount rate should reflect this: 9.72% × 1.30 ≈ 12.6% (or adjust beta upward).
- Different tax jurisdiction – the 15% local tax rate and 12% withholding tax change the after-tax cash flows and the effective cost of debt.
- Ring-fenced financing – if the subsidiary is separately financed, the group WACC does not reflect its capital structure.
- Currency risk – cash flows are in a foreign currency; the discount rate should be in the same currency or the cash flows converted at forward rates.
Using 9.8% would overstate NPV and could lead to accepting a value-destructive project.
2. Compute the project NPV using an appropriate project-specific discount rate and state your recommendation.
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Project-specific rate: 12.6% (approx.).
NPV of Rs 150m for 5 years at 12.6%:
- Annuity factor = [1 − (1.126)^-5] / 0.126
- (1.126)^5 ≈ 1.809 → (1.126)^-5 ≈ 0.5528
- AF = (1 − 0.5528) / 0.126 = 0.4472 / 0.126 ≈ 3.549
- PV of inflows = 150 × 3.549 = Rs 532.4 million
- Less initial outlay Rs 600m → NPV ≈ −Rs 67.6 million
Withholding tax adjustment: If dividends are repatriated, the 12% WHT reduces cash flows. Effective cash flow = 150 × (1 − 0.12) = Rs 132m → PV = 132 × 3.549 = Rs 468.5m → NPV ≈ −Rs 131.5 million.
Recommendation: Reject the project on both bases. The CFO's 9.8% rate would have given: AF at 9.8% ≈ 3.82 → PV = 573 → NPV ≈ −Rs 27m - still negative but materially less so. The project destroys value once risk and repatriation are properly reflected. Management should renegotiate the outlay, seek a higher price, or abandon.
3. The CFO proposes funding the project entirely with debt in the subsidiary to 'save tax'. Evaluate this financing proposal.
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Evaluation:
Potential benefits:
- Interest is tax-deductible locally (15% rate) → tax shield.
- Removes the need for equity repatriation and the 12% WHT on dividends.
Risks and costs:
- Thin capitalisation rules – many jurisdictions cap interest deductions at a fixed debt:equity ratio (e.g., 1.5:1 or 4:1 under BEPS Action 4). 100% debt is likely to be disallowed.
- Transfer pricing – the interest rate must be arm's length; a high rate could be challenged.
- Withholding tax on interest – often higher than on dividends (e.g., 15–20%); the 'saving' may be illusory.
- Currency and refinancing risk – debt in a foreign currency exposes the group to FX losses on translation.
- Loss of group tax shield – interest deductions at 15% are worth less than at 25%; the group may be better off borrowing at parent level.
Conclusion: The proposal is not a simple tax win. Model the after-tax, after-WHT cost of each financing route, check local thin-cap rules and the tax treaty, and consider a mix of debt and equity that respects the local capital structure. Recommend a transfer-pricing study before implementation.