The Hindu Business Line : Indian glass to Iraqi border

YOU have been asked to give advice to a medium-sized glass manufacturer in India which is tendering for an order in Kuwait, for which, payment will be made in Kuwaiti dinars in 18 months. The company is unsure about what price to quote. Marginal cost of producing the glass is shown in Table 1. Exchange rate, Spot: Rupee/dinar — 159.20-30 = One KD. The other details are given in Table 2.

Required: a) Recommend what price should be quoted in the tender by the Indian glass manufacturer.

b) Assume that you are the chief finance manager of another glass manufacturer located in Italy competing and participating in the same tender. Discuss whether you would be able to protect yourself in any manner, against exchange fluctuation risks of the lira (assuming the problem relates to pre-euro situation) against the dinar, if the lira to depreciate by 5 per cent annually. No computations are called for. (10 marks)

Solution: Glass manufacturer in India: i) Inflation rates in India are seen to be higher than in Kuwait. This implies that the rupee is likely to fall in value against the dinar over the next 18 months. The glass manufacturer has to take this into account when tendering, to avoid overpricing the quote.

ii) The likely future exchange rate can be estimated on the basis of either the relative inflation rates or on the basis of interest rates. In this case, the former approach (inflation-based approach) will have to be used, as evidence gathered over time suggests that this is a better predictor of future-spot-rates, than interest rates per se.

iii) Using market interest rates will not yield meaningful results.

iv) Using purchasing power parity theory, the rupee can be expected to depreciate, and the expected future spot rate at the end of the eighteenth month is as follows:

Step I: One-year horizon (full year)

1 + inflation rate in foreign country / 1+ inflation rate in domestic currency = Spot / forward

1.03 / 1.09 = 159.20 / forward

One-year horizon expected future rate = Rs 168.48 per dinar

Step II: 12 to 18th month (half-year)

Additional six months = 168.48 x 1.045 / 1.015 = 173.45 (rounded off value)

Estimate of future spot rate of rupee = Rs 173.45 per dinar

v) Marginal cost — Rs 580 lakh (working note 1)

Mark up — 25 per cent

Normal tender price — Rs 725 lakh

vi) Assuming exchange rates are in equilibrium, with reference to inflation rates, tender price of Rs 725 lakh would have to be translated in terms of dinars, at estimated future spot rate, namely, 173.45 per dinar. This will help retain the competitive edge.

vii) Computation showing tender price: Rupee price — Rs 725 lakh; conversion rate — Rs 173.45 per dinar; estimated tender value — dinar 417,987.89, rounded off to dinar 417,988;

Add: Expenses incurred in K-dinars, for securing contract documents, and so on — dinar xxxx

viii) Total contract price: The price to be quoted in the tender will be dinar 417,988 + costs, if any, incurred in Kuwait for securing contract documents, and so on.

Working note 1: Cost per square foot, Rs 2,90,000; total quantity 2,00,000; quantity x cost, Rs 580 lakh

The case of an Italian competitor: This is only a tender stage. Since a definite order has not been received, the preferred means of hedging at this stage would be a currency option to sell Kuwaiti dinars (obtainable from a bank). The option needs to be exercised only if the business is secured. If the tender were to be unsuccessful, the only cost would be the option premium. The company can take an option for the entire 18 months, or for a shorter period until the time at which the tender will be decided.

Option contracts are traded in the foreign currency options marketAn option contract for a shorter tenure is preferable, that is, until the tender results are likely to be known.

Depending on the corporate "attitude to risk" another view can be taken. Since this is only a tender stage, the element of risk is minimal, and one can leave the position open, until tender results are known. Thereafter, a forward contract or a futures contract for sale of dinars against the lira can be taken.

Cash in Maldives

MPR Ltd, a leading manufacturer exporter, has been adopting HDFC's rate of 10 per cent as nominal rate. Based on this and all other relevant risk factors, the company had derived a hurdle rate of 16 per cent for evaluating the cash flows of their domestic projects. Indications in the recent budget are that there is a rate-cut by 1 per cent, and the benchmark cost of capital rate would also have to be adjusted suitably.

MPR Ltd proposes setting up a project in Maldives, where State Bank of India is offering a 5 per cent rate, identical to that of HDFC in India. The CEO of MPR has sought your help in arriving at a rate, which he can use for evaluating the cash flows of the Maldivian project. Advise. (4 marks)

The focus of the question is to determine the risk-adjusted discount rate for Maldives taking the same basis as MPR is following in India.

Other aspects being equal, the risk-adjusted discount rate is derived thus: 1+ risk-adjusted rate = 1+ nominal rate x 1+ risk premium. This is shown in Table 3.

The revised hurdle rate for MPR's domestic projects is Rs 14.50 per cent.

It is assumed that risk-premium levels will be the same for MPR, irrespective of the location of project.

The rate at which cash flows of the Maldivian project would be evaluated is 10.72 (rounded off to 10.75 per cent)

The cost of capital for evaluating the Maldivian project is 10.72 or 10.75 per cent.

Project X

A COMPANY is considering a project with an initial outflow of Rs 10,00,000. The project life is 10 years. There is no scrap value. The company estimates the cash flows of the project for each of the five years — one-five and six-ten — as shown in Table 4.

Required: i) recommend if the company can accept the project, evaluation being on a risk-adjusted discount rate of 16 per cent, and the project is entirely financed out of equity.

ii) Assume that the debt capacity of the company is 60 per cent; appropriate loan is raised at 10 per cent interest payable annually, principal repayment is at the end of 10 years, and the tax rate is constant at 40 per cent. Will your answer differ? Give reasons.

iii) What are your observations as to the sensitivity of the project to a) changes in interest rate on the debt being raised by the company; and b) changes in tax rate? (15 marks)

Solution: Step I: Ascertaining probable cash flows from years 1-5 and 6-10 (see Table 5).

Step II: Determining present values, and NPVs, applying a discount rate of 16 per cent (see Table 6).

Step III: Analysis and recommendation.

Evaluating the project on a discount rate of 16 per cent (as shown in step II), the NPV is negative at Rs 80,000. The base-case NPV under an all-equity financing approach, is thus seen to be negative. Going purely by base-case approach, the project is rejected.

Recommendation: NPV is negative. Reject.

ii) Evaluation of the project based on APV approach: The following points are relevant:

a) Company can raise a debt of 60 per cent. Value of debt is therefore: Rs 600,000 (60 per cent of Rs 10,00,000);

b) The interest rate is 10 per cent. Annual interest payable is, therefore, Rs 60,000;

c) Tax rate is 40 per cent. Tax shield on interest is Rs 60,000 x 40 per cent = Rs 24,000

d) PV of saving effected through project life of 10 years, using a discount rate of 10 per cent (risk-free rate at which loan is raised) is computed thus:

PV annuity factor for a rate of 10 per cent for 10 years is 6.114

Rs 24,000 x 6.114 = Rs 146,736

e) Computation of APV: NPV as originally computed (Step III) = Rs (80,000)

Adjustment to be made in the PV (add 146,736) = + 146,736 APV = Rs 66,736

Based on APV approach, the project can be accepted.

Reasoning for change in recommendation (relative to Step III): If the company had a debt capacity of 60 per cent, and a loan of Rs 600,000 is raised at 10 per cent for the tenor of the project, there would be a tax shield of Rs 24,000 annually. The PV of this tax shield, if captured into the project appraisal, the project yields a positive PV of Rs 66,736.

iii) Sensitivity of the project to interest rate on debt: a) base-case NPV is a negative Rs 80,000

b) If the PV of tax shield were to be lower than Rs 80,000, the project will not yield a positive NPV.

c) If we reckon interest at 10 per cent, for a tax shield of 40 per cent, the adjustment to base case NPV is +146,736

d) With every percentage fall in interest rate, tax shield would also come down. This is shown in Table 7.

It is seen that the PV of tax shield falls below Rs 80,000 at an interest rate of 4 per cent. The company's present proposal is to raise the debt at a rate of 10 per cent. In case the interest rate falls to 4 per cent, the positive side-effect would be nullified.

Sensitivity of the project to interest-rate change is 60 per cent compared to the present level of 10 per cent, that is, a drop of 6 per cent from the base of 10 per cent.

On the same lines, tax-shield will come down with a drop in the tax rate. At present, the tax rate is 40 per cent. The adjustment provided by the tax-shield is Rs 146,736 on a base-case NPV of Rs 80,000. The positive NPV is Rs 66,736. This works out to 45.48 per cent of Rs 146,736. Accordingly, a fall in tax rate beyond, say, 46 per cent (of 40) will affect the NPV of the project.

Let us consider a tax rate of 21 per cent (a fall of 47.5 per cent). At 21per cent tax rate, the PV of tax shield is Rs 77,414 which is less than Rs 80,000 (see Table 8). The project does not yield a positive PV at that tax rate.

The sensitivity to tax rate can be rated as a drop of 46 per cent on the present tax rate of 40 per cent.

(To be concluded)

(Suggested answers to a CA (Final) model paper on management accounting and financial analysis prepared by Prime Academy, Chennai.)

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