The Project That Clears the Hurdle - Just
Jamuna Foods Ltd is evaluating a 5-year expansion requiring an initial outlay of Tk 60,000,000. Forecast annual operating cash flows are Tk 18,000,000. The company's weighted average cost of capital is 12%, but the project is in a new region and the finance team believes a risk premium of 3% is warranted. The company can borrow Tk 40,000,000 at 10% (interest deductible at 27.5%) and fund the rest from retained earnings. The board's stated policy is a 4-year payback. A director argues: 'The NPV is positive at 12%, so we should go; the risk premium is just conservatism.'
1. Evaluate the project using NPV at both discount rates and the payback rule. What is the correct decision and why?
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Annuity factor, 5 years: at 12% = 3.6048; at 15% = 3.3522.
NPV at 12%: 18,000,000 × 3.6048 = 64,886,400 − 60,000,000 = +Tk 4,886,400.
NPV at 15%: 18,000,000 × 3.3522 = 60,339,600 − 60,000,000 = +Tk 339,600.
Payback: 60,000,000 / 18,000,000 = 3.33 years - within the 4-year policy.
Decision analysis. The project clears both hurdles, but the margin at the risk-adjusted rate is only Tk 339,600 - about 0.6% of the outlay. That is inside any reasonable forecast error. A 5% shortfall in annual cash flow (18,000,000 → 17,100,000) at 15% gives 17,100,000 × 3.3522 = 57,322,620, i.e. NPV −Tk 2,677,380. The project fails on a modest adverse variance.
On the director's argument: the risk premium is not 'conservatism' - it is the price of uncertainty in an unfamiliar region. Using the company WACC for a project of different risk is a classic error: the WACC reflects the average risk of existing operations. The correct discount rate is the one that reflects this project's risk.
Correct decision: do not proceed on the current case. The NPV at the risk-adjusted rate is too thin to be robust. Either renegotiate the outlay, secure a higher or contracted cash flow, or phase the investment to limit exposure. The payback rule passing is not decisive - payback ignores cash flows after the cutoff and the time value of money.
2. The finance team proposes using the 10% borrowing rate as the discount rate 'because that is what the project actually costs to finance'. Critically assess this.
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This is the financing-mix fallacy. The discount rate in an NPV calculation should reflect the opportunity cost of capital for the project's risk, not the cost of the specific funds raised. Three reasons:
- It ignores the equity component. Tk 20,000,000 is funded from retained earnings, which carry an equity cost. Discounting only at the debt rate implies equity is free - it is not; shareholders forgo returns elsewhere.
- It ignores the tax shield correctly applied. The after-tax cost of debt is 10% × (1 − 0.275) = 7.25%, not 10%. Using the pre-tax rate overstates the cost of debt and understates the true WACC simultaneously - the errors do not cancel.
- It confuses source with use. How a project is financed affects the financing decision, not the investment decision. Mixing them lets a cheap loan make a bad project look good.
What the team should do: compute a project-specific WACC or, better, an asset-beta-based rate reflecting the new region's risk. If the debt is project-specific, the tax shield can be valued separately (APV approach), but the operating cash flows should still be discounted at an unlevered rate appropriate to the asset's risk.
Judgement tested: the candidate must recognise that 'this is the rate we actually pay' is not a valid basis for project appraisal, and must be able to articulate why the WACC, not the debt rate, is the starting point - and that the WACC itself must be risk-adjusted for a project outside the company's normal operations.