Cement Expansion: The Discount Rate Mistake That Flips the Decision
A listed cement producer is appraising a 2.4mt brownfield grinding and clinker line with capex of PKR 45bn, to be funded 60% debt at KIBOR+250bp (KIBOR 11.5%) over six years and 40% equity. All revenue is in PKR, but coal is imported and is 45% of cash cost. The ten-year PIB yields 12.5%, the equity risk premium used by the company is 6.0% and the relevered beta is 1.15. The corporate tax rate is 29%. At an expected 75% utilisation and an EBITDA of PKR 3,000 per ton, the project generates EBITDA of PKR 5.4bn; depreciation is PKR 2.25bn over twenty years and sustaining capex is PKR 0.5bn a year. The CFO wants to discount the PKR cash flows at a 9% USD WACC, arguing cement is 'a dollar business' because inputs are imported. At that rate the NPV is roughly zero and he recommends proceeding.
1. Compute the correct PKR WACC and evaluate the CFO's 9% discount rate.
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Cost of equity (CAPM). 12.5% + 1.15 x 6.0% = 19.4%.
After-tax cost of debt. 14.0% x (1 - 0.29) = 9.94%.
WACC. 0.60 x 9.94% + 0.40 x 19.4% = 5.96% + 7.76% = 13.7%, against the CFO's 9%.
Why the 9% is wrong. The currency of the cash flows and the currency of the discount rate must match. These cash flows are in PKR and contain PKR inflation (roughly 7%) in selling prices, wages and energy. A USD WACC embeds US inflation of about 2.5%. Discounting PKR cash flows at a USD rate mixes a high-inflation numerator with a low-inflation denominator and mechanically inflates the present value by roughly the cumulative inflation differential.
The legitimate version of the CFO's argument. The coal exposure creates a revenue-cost mismatch, not a currency-of-cash-flow mismatch. The right response is either (a) discount PKR cash flows at 13.7%, or (b) convert every PKR cash flow to USD at projected forward rates and then discount at a genuine USD WACC - which, after adjusting for the country risk premium Pakistan carries, would not be 9% either.
Conclusion. Reject the 9% rate. The correct hurdle is 13.7%, roughly 470bp higher, and at this project's cash-flow profile that gap is decisive.
2. Using the 13.7% WACC, compute the project's steady-state free cash flow, NPV and value creation, and state a recommendation.
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Build the free cash flow.
- EBITDA: 1.8mt x PKR 3,000 = PKR 5.40bn
- Less depreciation 2.25bn = EBIT 3.15bn
- Tax at 29% = 0.91bn, NOPAT = PKR 2.24bn
- Add back depreciation 2.25bn, less sustaining capex 0.50bn
- Steady-state FCF = PKR 3.99bn
NPV as a perpetuity. 3.99 / 0.137 = PKR 29.1bn against capex of PKR 45bn → NPV approximately negative PKR 15.9bn. The project destroys roughly a third of its capital.
The 9% comparison shows the trap. 3.99 / 0.09 = PKR 44.3bn, NPV approximately -0.7bn - 'rounded to zero, proceed'. A 470bp error in the discount rate is the entire investment decision. This is precisely why the discount-rate judgement, not the demand forecast, is the examinable point.
Break-even test. Setting the perpetuity equal to PKR 45bn: required FCF = 45 x 0.137 = PKR 6.17bn. Solving 0.71 x EBITDA - 0.71(2.25) + 2.25 - 0.50 = 6.17 gives EBITDA ≈ PKR 8.47bn, or about PKR 4,700 per ton at 1.8mt - 57% above the assumed PKR 3,000.
Recommendation. Reject at the base case. The company would need either a price/EBITDA environment 57% better than assumed, or capex roughly 35% lower, to earn its cost of capital. Given industry utilisation near 65% and a 2.4mt addition to national capacity, a 57% margin uplift is not a defensible planning assumption.
3. What sensitivities and terminal-value judgements would you require before the board votes?
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Currency sensitivity, not currency discounting. If the rupee depreciates 10% and coal is 45% of cash cost, cash cost rises by roughly 4.5%. Against a fixed PKR selling price, EBITDA per ton falls by around PKR 600–700 depending on the cost base. At PKR 2,400 per ton, FCF drops to about PKR 3.2bn and NPV to negative PKR 22bn. The correct treatment of the coal exposure is a margin sensitivity plus a hedging plan, not a lower discount rate.
Utilisation. At 65% utilisation EBITDA falls to PKR 4.68bn, FCF to PKR 3.4bn - still below the PKR 6.17bn break-even. The project only works above roughly 78% utilisation at PKR 3,000 per ton.
Terminal value discipline. The FCF perpetuity assumes zero real growth and no capacity additions, which is conservative and appropriate. But it must also assume the plant is replaceable at the same cost and that the 20-year depreciation is matched by real sustaining capex; PKR 0.5bn a year (about 1.1% of capex) is low for a cement line, where refractory and mill relining are heavy. Test PKR 1.0–1.5bn sustaining capex, which reduces FCF to PKR 3.0–3.5bn.
Other required tests. A KIBOR +300bp debt stress showing interest cover; a two-year delay to first clinker with capitalised interest; and a check that the relevered beta of 1.15 reflects 60% leverage (unlever and relever at the project's own gearing rather than the group's).
Vote. With NPV negative at the base case and worse under every plausible sensitivity, the board should defer and re-tender capex before committing.