Zenith Chemicals: WACC, a Rupee-versus-Dollar Funding Choice, and an Export Receivable
Zenith Chemicals is appraising a PKR 4.2 billion chlor-alkali expansion expected to generate after-tax operating cash flows of PKR 900 million a year for ten years, with no terminal value. It will be financed 60% debt / 40% equity, consistent with the firm's target capital structure. The bank has offered a five-year loan at KIBOR + 350bps; KIBOR is 11.5%. Zenith's equity beta is 1.10, the 12-month T-bill yield is 9.0% and the market risk premium is 6.0%. The tax rate is 29%. Separately, Zenith expects USD 6.0 million from an export customer in 90 days. Spot is PKR 276.50/USD; the 90-day forward is PKR 279.00. The treasurer argues the loan should instead be raised in dollars at SOFR + 400bps, i.e. 9.25%, because it is '5.75 points cheaper'. The CFO wants an analysis before the board meets.
1. Calculate the WACC and appraise the project. What sensitivities should the board see?
Read the worked answer
Cost of equity (CAPM)
- ke = 9.0% + 1.10 × 6.0% = 15.6%
Cost of debt
- Pre-tax kd = 11.5% + 3.5% = 15.0%; post-tax = 15.0% × (1 − 0.29) = 10.65%
WACC
- 0.40 × 15.6% + 0.60 × 10.65% = 6.24% + 6.39% = 12.63%
Appraisal
- Ten-year annuity factor at 12.63% = 5.51
- PV of operating cash flows = 900m × 5.51 = PKR 4,955m
- NPV = +PKR 755m; IRR ≈ 16.8%
The project clears the hurdle, but the margin is not large. Sensitivities the board must see:
- A 15% shortfall in annual cash flow (down to PKR 765m) or a rise in WACC to 16.8% eliminates the NPV entirely.
- NPV is 18% of the initial outlay - within normal forecasting error for a first-of-kind plant.
Caveats on the calculation itself
- Using the firm's WACC assumes the project has the same business risk as the existing portfolio. Chlor-alkali may have different cyclicality; a project-specific beta would be better.
- The loan is five-year but the asset is ten-year. Using a five-year KIBOR-based rate understates the true cost of funding a ten-year asset - refinancing risk is real and should be priced, i.e. use a ten-year reference rate or add a refinancing premium.
- The PKR 900m must be genuinely after-tax operating cash flow, before financing. If it already deducts interest, discounting at WACC double-counts the tax shield.
Conclusion Accept, subject to (a) confirming the cash flow forecast is post-tax and pre-financing, (b) matching debt tenor to asset life, and (c) board-level acceptance that the headroom is thin.
2. Evaluate the treasurer's dollar-loan proposal and advise on hedging the USD 6.0 million receivable.
Read the worked answer
The dollar loan: the 5.75 points are largely illusory Nominal rates across currencies are not comparable. Interest rate parity implies the PKR is expected to depreciate by roughly (1.15/1.0925) − 1 = 5.3% a year for the two loans to be equivalent. The treasurer is comparing a nominal PKR rate with a nominal USD rate and ignoring the currency path.
However, the observable market does not support 5.3%. The 90-day forward premium is (279.00 − 276.50)/276.50 = 0.90%, about 3.6% annualised. Hedging the dollar loan for one year therefore costs:
- (1.0925 × 1.0362) − 1 = 13.2%, against 15.0% for the PKR loan.
So on a one-year hedged basis the dollar loan is genuinely cheaper - but:
- Forward points beyond 12 months are illiquid in Pakistan; the treasurer cannot lock 5.3% for five years.
- The project generates PKR cash flows. A dollar loan creates a currency mismatch that must be rolled and hedged, importing liquidity and rollover risk.
- Tax: interest withholding on cross-border interest and thin-capitalisation limits reduce the apparent benefit.
Advice: dollar funding is defensible only for the hedged, short-dated portion and only where a natural USD offset exists. For a ten-year PKR-revenue asset, do not fund in dollars on the strength of the nominal rate gap.
The USD 6.0m receivable
- Forward locks 279.00 → PKR 1,674m versus 1,659m at spot.
- The forward is an unbiased estimate of the future spot, not a forecast, so hedging does not cost expected value - it removes variance. Recommended if the receivable is firmly committed.
- Hedge ratio: 100% if there are no USD payables. If Zenith imports cotton or spares, net the exposure first and hedge only the residual.
- If the receivable is forecast rather than contracted, use an FX option or a partial (50–75%) forward to avoid creating a speculative position.
- Document the hedge relationship if IAS 21/IFRS 9 hedge accounting is desired, so the gain or loss offsets in OCI rather than hitting a volatile P&L.