How investors can reap the fruits despite the thorns?
The Central Bank of Egypt’s (CBE) decision to raise interest rates has led to an increase in the internal rate of return (IRR) for investors. How can they achieve such a higher target IRR, given the lower purchasing power of consumers?
By Markets Chimp
6/18/17 11:09 PM
Mahmoud Gad, CMA
In our previous article titled “Investors' dream of La-La Land in Egypt, despite CBE decisions!”, we concluded that rising interest rates, after the flotation of the local currency, led to an increase in investors’ target internal rate of return (IRR). Hence, their acceptance or rejection of any new investment depends on their ability to achieve this new target IRR. At the same time, investors face two other challenges following the flotation decision: (1) higher costs and (2) lower consumers’ purchasing power.
Let the Numbers Speak
There is a saying that “Numbers are the language of business”. In their journey to explore investment opportunities east and west, investors do not care what language the countries’ people speak. Investors are only fluent in the language of business which is “numbers”. Noting that investors’ decisions are more sensitive to numbers than words, we present below in this article a “sensitivity analysis” by numbers, to clarify how investors’ decisions are sensitive to change in: (1) demand, (2) inflation, and (2) interest rates.
An Exemplary Case Study
Let’s consider this example. In 2016, before the flotation decision, a company operating in the Egyptian market planned to make some expansions by adding new product lines for some of its products. The company was aiming to maintain or increase its market share, given the population growth. Below we present the feasibility study for one of these lines before and after the flotation decision.
1. Pre-flotation – Base Case Assumptions
In the table below, we present the basic assumptions for a feasibility study prepared based on prices and costs before flotation of the Egyptian pound.
The investment cost for the production line is projected at EGP1,000,000.
Working capital of EGP100,000 that will be recovered at the end of the project’s life (five years).
The production capacity for the product line is 12,000 units per annum (p.a.), and the company is expected to sell 10,000 units in Year 1 with an annual growth of 2% (population growth).
Selling price per unit is projected at EGP100.
Variable cost is EGP60 per unit.
Fixed cost in Year 1 is EGP50,000.
It is assumed that both prices and costs will increase by the expected inflation rate of 13%. The weighted average cost of capital (WACC) is calculated as 23.6%, assuming a debt-to-capital ratio of 25%. Hence, the target IRR must not be lower than 23.6%. Please read our last article where we explained how to calculate the WACC.
Preparing the Investment Feasibility Study
As shown in the table below, we evaluated the feasibility of the new product line by projecting its annual cash flows over its estimated life, then we calculated its expected IRR. We note that the expected IRR of the production line is 23.6% equal to the WACC of 23.6%. Hence, the project was accepted.
2. Post-flotation – Modification of Assumptions
As a result of high inflation and interest rates, the following occurred:
Prices and costs surged by 30%.
The WACC increased to 26.2%.
Therefore, we had to re-examine all implications using a sensitivity analysis.
Sensitivity Analysis of the Investment Decision After Flotation
We have re-prepared the feasibility study after a modification of prices and costs to reflect the inflation rate after flotation. We assumed the following:
The company is able to increase prices and costs by the same percentage of inflation,
The increase in selling prices in the market would increase the costs by the same percentage,
Both (1) growth in demand and (2) inflation rate are unknown in 2017 and 2018.
But what sort of “demand growth” and “inflation rate” need to be achieved in 2017 and 2018 in order to achieve the new higher target IRR of 26.2%? Kindly note that this is not a question as to what rates are expected in the market but rather what rates investors should have in order to achieve their new higher target IRR.
To answer this question, we have prepared a sensitivity analysis showing how we can achieve the IRR of 26.2% at different rates of demand (+5% to -5%) and different rates of inflation (10% to 30%). Please see the table below:
Accordingly, achieving the new IRR would require inflation rates to remain high in 2017 and 2018. For example, if demand surged by 5% in 2017 and 2018, inflation would need to reach 20% in both years. If demand declined by 5% in 2017 and 2018, inflation would need to reach 35% in the same years. Kindly note that we assume the company’s ability to increase prices at a percentage equal to the change in costs. In other words, this will be worse for companies that cannot do that.
To further understand the above table, we divided it into four quadrants (a matrix) according to the rates of growth in demand and inflation, as follows:
CBE’s decisions have confused investment decision makers over the past few months due to increased burdens across the three activities: finance, investment, and operation. This may push investors, because of increased costs and risks, to prefer “a bird in the hand” rather than “two in the bush”, i.e. (investing in debt instruments instead of entering into investment projects). Therefore, I believe that the CBE’s decisions will prove successful only by:
Setting an action plan involving all parties related to investment, led by the CBE, to set integrated objectives and goals in order to attract more investments,
Exploiting the decline of the local currency in growing exports,
Finding local substitutes to imported goods.
Encouraging domestic consumption, combined with increased supply, to drive demand growth and price stability.
All of the above should help achieve economic growth and create more job.