Indus Renewables: WACC, Project Risk and the Capital Allocation Decision
Indus Renewables is considering a five-year solar installation. Capital cost is PKR 1,200 million, depreciated straight-line to nil. Annual revenue is expected at PKR 600m and cash operating costs at PKR 280m. Working capital of PKR 80m is required at the outset and recovered at the end of year 5. Tax is 29%. The company targets 60% debt at 11% pre-tax and 40% equity at a cost of 16%. The project is in a new region with unfamiliar irradiation, grid-connection and counterparty risk. The board is also under pressure from a large family shareholder for a higher dividend after two flat years.
1. Compute the company WACC and the project's NPV. State your decision and the assumptions that matter most.
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WACC
- After-tax cost of debt = 11% × (1 − 0.29) = 7.81%
- WACC = (0.60 × 7.81%) + (0.40 × 16%) = 4.686% + 6.4% = 11.09%, say 11.1%.
Annual cash flow
- EBITDA = 600 − 280 = PKR 320m
- Depreciation = 1,200 ÷ 5 = PKR 240m
- Taxable profit = 80m; tax at 29% = PKR 23.2m
- NOPAT = 56.8m; add back depreciation = PKR 296.8m operating cash flow.
NPV at 11.1%
- Annuity factor (5 years, 11.1%) ≈ 3.68 → PV of operating flows = 296.8 × 3.68 = PKR 1,092m
- PV of working-capital recovery = 80 ÷ 1.111^5 ≈ 80 ÷ 1.693 = PKR 47m
- Initial outlay = 1,200 + 80 = PKR 1,280m
- NPV ≈ 1,092 + 47 − 1,280 = −PKR 141m
Decision: reject on a pure NPV basis; the project destroys about PKR 141m of value at the company's cost of capital.
Assumptions that matter
- Constant EBITDA for five years; no ramp-up or degradation.
- No terminal or salvage value; no decommissioning cost.
- 60:40 gearing maintained and debt capacity available at 11%.
- Working capital fully recovered.
- Most important: that 11.1% is the right discount rate for this project. It is not - see next task.
2. The finance director argues that because the project is 'strategic', it should be judged at the company WACC. Critically evaluate this and recommend how the appraisal should change.
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The WACC is the wrong hurdle here. WACC reflects the risk of the existing asset portfolio. The new region carries unfamiliar irradiation, grid and counterparty risk. Using 11.1% would overstate value and systematically push the firm into its riskiest ventures - a classic cross-subsidy of risk.
What to do instead
- Risk-adjust the discount rate. Build a project-specific rate from a pure-play comparator's asset beta, relevered to 60:40. If comparable solar operators carry an asset beta implying, say, 15–16% equity cost in this market, the project WACC could rise to ~13–14%, making NPV more negative still.
- Or adjust cash flows with scenario and probability weighting: base, low-irradiation, grid-delay and counterparty-default cases. If the expected NPV across scenarios is negative, the project fails.
- Separate the strategic option from the cash flow. 'Strategic' is a legitimate argument only when it creates a identifiable option - a foothold, a licensed pipeline, a learning curve - with a value that can be estimated and a cost of acquiring it. A vague label is not a valuation.
- Apply a stage gate. Fund a small feasibility/permitting phase (e.g. PKR 40–60m) to resolve irradiation and grid risk, then re-appraise with better information. Buying information is cheaper than buying the asset.
- Sensitivity: the NPV is negative even at 10% (−PKR 105m), so the conclusion is robust to modest rate changes; only a large revenue increase or capex reduction rescues it.
Recommendation: do not approve at 11.1%. Re-run at a risk-adjusted rate and under downside scenarios; if still negative, decline or restructure (smaller phase, offtake-backed PPA, partner to share risk).
3. The large family shareholder wants a higher dividend. How should the board weigh this against the investment programme, and what signals would each choice send?
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The cash reality. The solar project is NPV-negative, so rejecting it creates PKR 141m of value relative to proceeding. That does not automatically mean the cash should be paid out - it means it should not be sunk into a value-destroying project.
Decision framework
- Fund only positive-NPV investments first. If the pipeline has none, excess cash has no productive internal use at the margin.
- Check covenants and liquidity. Debt repayment may be the highest-return 'investment' if it reduces cost or covenant risk.
- Then distribute. A higher dividend is defensible if the firm has no positive-NPV uses and a stable cash position.
Signalling
- Raise dividend now, then cut later - deeply negative signal; markets punish dividend cuts more than they reward increases.
- Maintain dividend and hold cash for a staged project - signals discipline and optionality, provided the board explains the stage gates.
- Special dividend or buyback - signals no growth pipeline; honest but may disappoint growth-oriented holders.
- Invest in a negative-NPV 'strategic' project - signals weak capital discipline and entrenches the family's preferences over minority value.
Recommendation: reject the solar project at current terms; allocate cash first to covenant safety and the feasibility-stage option, then declare a sustainable, clearly explained increase rather than a one-off gesture. Set a dividend policy tied to free cash flow and leverage so the family's expectation is managed by rule, not by annual negotiation. Minority shareholders should receive the same explanation in the annual report.