Slag Grinding Unit with Dollar Debt and Rupee WACC
Punjab Grinding Co. is adding a 1.2 million tonne slag grinding unit near Port Qasim at a total capex of PKR 8.0 billion. Of this, USD 15 million is imported mill equipment, priced and payable at delivery; the balance is local civil works and PKR equipment. The plant will sell 70% domestically at PKR 11,500 per tonne and 30% in export markets at USD 42 per tonne FOB. Imported coal and grinding media cost USD 32 million a year; local fixed costs are PKR 2.4 billion. The company can fund the USD portion with a three-year dollar loan at 9.0% or a PKR loan at 14.5%; the CFO discounts all cash flows at the 15.0% nominal rupee WACC. Current PKR/USD is 278. Management forecasts 6% US inflation and 11% Pakistani inflation. Tax is 29% with 15% reducing-balance depreciation, and the project life is 10 years. The board wants a rupee NPV and a break-even exchange rate.
1. Is 15.0% the right rate for the USD-denominated cash flows? Show how you would structure the analysis and what error the CFO's approach creates.
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No. A nominal rupee WACC compensates for Pakistani inflation and rupee depreciation. Applying it to USD cash flows mismatches the currency of the cash flow and the discount rate. If the CFO converts USD flows at today's spot rate and discounts at 15%, he implicitly assumes the rupee never depreciates; that overstates the rupee NPV. If he instead projects USD flows and discounts at 15%, he applies a rupee premium to dollar cash flows and double-counts country and currency risk.
Structure the analysis in one consistent currency. Either (a) convert every USD item to PKR using a forecast path consistent with relative purchasing power parity, approximately 11% versus 6% inflation, and discount at the 15% rupee WACC; or (b) discount USD cash flows at a USD WACC built from a US risk-free rate plus a project spread reflecting Pakistani sovereign and execution risk, then convert the resulting USD NPV at spot. The two should reconcile if the FX path and the spread are internally consistent. The 15% WACC also needs adjusting if the chosen debt mix differs from the company's target capital structure; use APV or a project-specific WACC.
2. Estimate the break-even PKR/USD rate on the base case and recommend whether the dollar loan creates or reduces value.
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At PKR 278, domestic revenue is 840,000 t x 11,500 = PKR 9.66bn. Export revenue is 360,000 t x USD 42 = USD 15.12m, or PKR 4.20bn. Total revenue is PKR 13.86bn. USD operating cost is PKR 8.90bn and local fixed cost is PKR 2.40bn, leaving EBITDA of about PKR 2.56bn. After approximate depreciation and 29% tax, annual cash flow is about PKR 2.0bn; at the 10-year 15% annuity factor of 5.019, PV is about PKR 10.1bn against PKR 8.0bn capex, an NPV near PKR 2.1bn.
A 10% rupee depreciation raises export revenue by about PKR 0.42bn but raises USD coal cost by about PKR 0.89bn. The net pre-tax effect is about -PKR 0.47bn, or -PKR 0.33bn after tax, a PV loss of roughly PKR 1.68bn. Break-even depreciation is therefore about 12-13%, implying a rate near PKR 312-315. The dollar loan saves roughly 5.5 percentage points on USD 15m, about PKR 230m a year pre-tax, but it also creates a USD repayment obligation. Because export receipts are USD 15.12m a year, they naturally hedge the loan. Recommend the dollar loan only if the export contracts are firm and the loan tenor matches the project; a three-year loan against a ten-year asset creates refinancing risk.
3. The rupee depreciates 15% in year one and coal rises 20%. Explain the net exposure and one contractual hedge.
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The two shocks work in opposite directions on revenue but both hurt cost. A 15% depreciation raises export revenue from USD 15.12m by about PKR 0.63bn at the new rate, but it raises the USD 32m coal and media bill by about PKR 1.33bn. A 20% coal price rise adds a further PKR 1.78bn. The net pre-tax hit is roughly PKR 2.5bn, and the after-tax hit is about PKR 1.76bn a year, with a PV of about PKR 8.8bn. That would eliminate the base NPV.
The exposure is a mismatch: costs are USD-priced while 70% of revenue is domestic and priced in rupees. The domestic price of slag may rise with import parity, but only with a lag and only if local competitors also face the same cost. One contractual hedge is a fixed-price, fixed-tenor coal supply contract with a coal supplier, ideally denominated in PKR or with a capped USD index. A second is a rolling USD forward or option programme sized to 50-70% of the next twelve months' coal exposure, leaving some upside if the rupee strengthens. Do not hedge the full exposure with the three-year loan; the loan amortises while coal purchases continue for ten years.