Question

Samuel company, a toy retailer, is publicly listed in Hong Kong. The company is thinking of investing in natural gas wells in Russia. This would be a five-year project. The CEO of the company has employed you as a financial manager for this investment project. Explain to the CEO the major considerations, methods and challenges in determining the required rate of return for this project. Explain if there would be any difference in the estimation of required rate of return for a private firm or a publicly traded firm. Explain also whether it is important to consider the issue of operating leverage in analysing this project. The CEO says “ The cost of capital depends on the source of the money, not the risk of the project.” Do you agree? Explain and illustrate your explanation with example. (limit your answer to 450 words)

Answer 1

Answer:

Samuel company, a toy retailer, listed in Hong Kong ,  wants to invest in Natural gas wells in Russia . It is a five year project.

As CEO of the company concerns about return on the project , following are the major considerations, methods and challenges in determining the required rate of return for this project :

The major considerations of the project be :

1. Initial and subsequent Investment in the Project

2. Cash flow of the project

3. Taxes and fees and other charges applicable as the project is in other country

4. Infrastructure and operational costs

5. Borrowing costs etc.

Methods to be used in the project is discounted cash flow method of capital budgeting where NPV of the project is calculated to determine the profit of the project. It covers the all probable risks involved in the project.

Challenges in the project will be as follows:

1. Cross border costs to be paid ( It includes Taxes, fees, regulations etc )

2. Rate of return used for discounting

3. Uncertain risks like environment risks, economical risks etc.

4. To maintain required rate of return or above as per expectations of stakeholders

If there would be any difference in the estimation of required rate of return for a private firm or a publicly traded firm then, in such case if the required rate of return is less then it will affect adversely on the share price and outlook of investors of the company or vice versa.

To eliminate the most of the risk in the project, it is important to consider the issue of operating leverage in analysing this project. In Operating Leverage The contribution and the percentage of contribution to turnover is considered. It means it covers all variable costs required to earn the turnover be considered. The remaining amount which is contribution covers the fixed costs including interest cost, taxes etc.

The CEO says “ The cost of capital depends on the source of the money, not the risk of the project.”

I do not agree to above as source of money is decides or gives insight of cashflow in the project , But risk of the project depends on various factors which reflected in the rate of return i.e cost of capital of the project.

For Example , if risk free rate of return of the project is 6.5% and the risks and inflation is denoted as increase in 3.5% then the cost of the project is 10% instead of 6.5%. By discounting the cashflow of the project by cost of capital with risks involved gives true present value of the inflow. If we assume that the Cash flow after two years be $ 1,000,000 then,

PV as per only cost of capital be : $ 1,000,000 x ( 1/ 1.065 ) ² = $ 1,000,000 x 0.881659282 = $ 881,659.28

PV as per only cost of capital with risks of the project be : $ 1,000,000 x ( 1/ 1.10 ) ² = $ 1,000,000 x 0.82644628 = $ 826,446.28

If we see the above calculation then we know that if we consider only cost of capital then it over estimate the cashflow and ignores the risks which at the end results loss of $ 55,213 ( $ 881,659.28 -$ 826,446.28 )

Therefore, Cost of capital requires not only source of the money but risk of the project.