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1- YARN PRICE INCREASES
2- RESULTS: LOCAL COMMERCIAL RAND 
3-
ARIF HABIB INVESTMENT
4- REFORMS IN THE CAPITAL MARKETS
5- RECAPITALIZATION: CHANGING THE FORTUNE OF PROJECTS

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RECAPITALIZATION: CHANGING THE FORTUNE OF PROJECTS

 

Return on Equity (ROE) can be defined as the percentage return on equity investment from a project or a company.

 

By MUHAMMAD FARRUKH RASHEED
Mar 17 - 23, 2003

 

 

ROE plays a dominant role in decision making of investors. To maximize share holders' wealth which is prime goal of every organization, it is necessary that company must try to increase or maintain current ROE. So while considering a project current ROE should also be considered as important factor. Declining ROE results in decreased share price and company feels difficulty to get investment from equity market.

Net Present Value (NPV) is an important measure of project evaluation.

"NPV is present value of all future cash inflows minus present value of all cash out flows of a project under consideration. If NPV is greater than zero the project is considered feasible. Discount rate is usually the Opportunity Cost of Capital".

In general practice required rate of return on equity investment in company is taken as opportunity cost of capital while calculating NPV. If current ROE of company is greater than required rate of return, which is usually the case with growing companies than a project taken on the basis of positive NPV calculated by considering required rate of return on equity investment might decline over all ROE of company. For example a company whose required rate of return is 30% and current ROE is 40% will take a project whose return is 31% because of positive NPV but this project will bring overall return of the company to a level of less than 40%. In other words shareholders wealth will deteriorate.

In an article "NPV: Meticulous Measure of Project Evaluation?" written by me and Mr. Rehan Muneer Malik and published by Pakistan and Gulf Economist we suggested that current ROE should be taken as opportunity cost of equity in case the company has current ROE greater than required ROE.

It was pointed out by some analysts that in this case a lot of projects will be rejected and company will be left with very few or no options. In this article I shall try to prove that it is not necessary to reject a lot of projects by following our method of calculating NPV. I am of the opinion that by Recapitalization of projects a lot of projects can be made feasible in terms of ROE.

"Recapitalization is changing the debt and equity mix of the project to get targeted ROE"

Two step approach towards project evaluation is suggested here.

STEP 1

Calculate NPV of the project by using current ROE (in case if company is earning above required ROE) as cost of equity. If NPV is positive accept the project if NPV is negative follow the second step.

 

 

Let us consider the following project.

NPV is negative so we shall follow the second step.

Investment (once at Start of Project)

1,000,000

Individual Weights

WACC
Loan 400,000 40%
60%
34%
Equity 600,000

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Weighted Average Cost of Capital (WACC) 34%

Interest Rate
Required Rate of Return on Equity
Cost of Equity
Cash Flow 1 (C1)
Cash Flow 2 (C2)
Cash Flow 3 (C3)
Cash Flow 4 (C4)
Cash Flow 5 (C5)
Cash Flow 6 (C6)
Cash Flow 7 (C7)
Cash Flow 8 (C8)
Cash Flow 9 (C9)
Cash Flow 10 (C10)

25%
30%

40%
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000

NPV (19,207)

STEP 2

For recapitalization we have to find out that what is the minimum level of debt & equity in the capital structure of project in order to make this project feasible in terms of ROE. We know that minimum acceptable NPV is 1. And at this level of NPV it means that project is almost giving ROE of 40%.

Details of calculations are given at end.

Investment

1,000,000

Individual Weights

WACC

Loan

468,315

47%
53%

33%

Equity

531,685

Weighted Average Cost of Capital (WACC)

33%

Interest Rate
Required Rate of Return on Equity
Suggested Cost of Equity
Cash Flow 1 (C1)
Cash Flow 2 (C2)
Cash Flow 3 (C3)
Cash Flow 4 (C4)
Cash Flow 5 (C5)
Cash Flow 6 (C6)
Cash Flow 7 (C7)
Cash Flow 8 (C8)
Cash Flow 9 (C9)
Cash Flow 10 (C10)

25%
30%
40%
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000

NPV

1

 

 

Thus from above example it is clear that just by changing capital structure we can make a project feasible in terms of ROE. It also shows that 47% of debt and 53% of equity is minimum required capital structure of the project to gain targeted ROE.

If this capital structure is not affordable for the company i.e. may be prudential regulation doesn't allow more than certain level of debt etc. than project will be rejected.

[NPV= C1/ (1+i) + C2/ (1+i)*(1+i).................... - Initial Investment (Equation 1)

As (i) is Weighted Average Cost of Capital (WACC) = Weight of loan * interest rate + Weight of equity * ROE (Current)

OR

WACC = Weight of loan * interest rate + (1- Weight of Loan) * ROE (Current)

Putting above value of (i) in Equation 1 and interpolating it for weight of loan we get the requisite weight of loan. From this we can determine weight of equity also.

Other values placed are.

NPV= 1, ROE=40%, i= 25% and all values of cash flows and initial investment as mentioned in tables.]

Special acknowledgement is due to Mr. Hashir Ibne Irshad, Faculty member, Foundation Institute of Management & Computer Sciences who has pointed out various valuable point in previous article which acts as starting point of this article.