June 2018 Ruva

Hi Sir John Moffat,
1) what is the discount rate for phase 1 and phase 2? I use all equity cost of equity engaged same as project E at 12% and apply in MM prop 2 (tax) and obtain new WACC. And I got 11%.
2) Is the scenario in Ruva project E an option to expand rather than option to delay? For construction industry, normally it would’ve been option to abandon.
3) investment 320m in year 4 for phase 2 would be discounted at 5% kd as per question.
I got negative NPV with cost of debt but positive NPV if discounted at WACC 11%.

If cost of debt is more reasonable, what is the reason for this? Do I make assumption that the reason is cos investment 320m is entirely financed out from debt financing with outlook that soft capital rationing limits the investment? Also optimum capital structure at best with increase of debt and obtain the tax benefit.

Therefore reject Project E on director’s proposal .

4) how real options build on NPV when evaluating investment decision?
It considers uncertainty in the future and add/reduce the value to have the option to expand/delay over time and volatility of project as compared to without the option. Hence BSOP model is used on phase 2 and traditional NPV on phase 1. Extra investment undertaken if PV> investment.