International project appraisal is an integral part of the Advanced Financial Management syllabus.
The purpose of this series of articles is to assist your preparation for the exam by demonstrating how to attempt exam questions on this area of the syllabus. Coupled with a comprehensive mode of study and revision, you should be ready for whatever the exam may contain. International project appraisal will be a large component of your studies, and I will demonstrate a systematic method of answering a question on this topic for each section of the exam.
In this article, I will demonstrate how to answer a ‘Section B’ style 25-mark question.
Penn Co
Penn Co is successful company based in a European country where the local currency is the dollar and inflation has been stable at 5% pa. Income tax is charged on company profits at the rate of 25% and is payable in the same year as the profits are earned.
The company is listed on several major stock exchanges as it has operations all over the globe. Its market capitalisation is $655m. The company has bonds with varying maturities trading at $145m.
The treasury department of the company regularly computes the company’s nominal cost of capital and this has been fairly stable at 10%. However, when Penn Co have carried out projects in developing markets it has used a nominal risk-adjusted rate of 12%.
Penn Co’s primary business is construction and laying of train tracks and tramlines. Their main consumers are governments due to Penn Co’s position as the market leader. Penn Co has a record of completing long and complex contracts within schedule, as well as conducting its business in an ethical manner.
The CEO of Penn Co recently attended a trade delegation to Africa where he met the prime minister of the fast developing country called Zanadia. The prime minister and his political team provided Penn’s CEO with an outline of a contract that the Zanadian government would like to award to Penn Co.
Tramline project
Zanadia is situated on the African West coast, with the local currency being the dinar. Although being relatively small when compared to its neighbours, its economy has grown at over 15% pa for the past five years, but this has led to an inflation rate currently running at 30% pa. The democratically elected government has taken full credit for this economic prosperity.
The prime minister is adamant that the performance of the country is a result of trade links he created with European-based multinational corporations (MNCs). He believes that by encouraging investment from these entities in his country, the MNCs will generate substantial returns with minimal risk, as many of the projects are government contracts.
There has been varied success when European MNCs have invested in Zanadia, with political interference, particularly from the prime minister, being blamed for below par returns. Rumours have been rife that the prime minister has been ordering his government to make ad hoc requests for payments to be made at various times during the contracted period. The government themselves have stated that, on a very rare basis, penalty charges have been levied when companies have not been keeping to schedule.
The Zanadian government’s latest project is to create an environmentally friendly electric tramline network to connect all areas of Enat, which is Zanadian’s capital city. The project will ultimately take 20 years to complete. However, the initial contract will be to lay the tramline to connect Enat to the national airport located 23 kilometres away. Providing this is completed to the satisfaction of the Zanadian government, they will extend the contract to allow initial supplier connect the rest of the city.
Following the recent meeting between the prime minister and the CEO of Penn Co, the prime minister has authorised his government officials to release financial projections to Penn Co to allow it to assess the financial viability of the contract.
Financial details
The government will pay a fixed price of dinar 5000m for the initial contact to lay the tramline between Enat and the national airport. This will be paid in stages: