Melamchi Water Supply Project

Melamchi Water Supply Project

FSB Team Pancha

Melamchi Water Supply Project

Teaching Notes

Synopsis:

This case is set is January 2014, as the Executive Directorof the Melamchi Water Supply Development Board (MWSDB) is considering who he should approach for $25mm in additional funding to cover the cost overruns of the Melamchi Water Supply Project (MWSP). The Government of Nepal (GON) and other stakeholders of the project would like to see private sector involvement in this project, however this has remained challenging due to the nature of the project and economic climate in the country.

At the time the project is funded by the Government of Nepal, which holds equity and a consortium of development banks, led by the Asian Development Bank (ADB) who have granted a series of very low interest, long term loans.

The case focuses around a number of key themes:

1. Valuation of a project in a developing country and the measurement of the various associated risks. The case leans on Campbell Harvey’s International Cost of Capital model to quantify the risk parameters.
2. Assessing the impact of economic subsidies that change the valuation of the project for different investors (development banks vs private investors).
3. The incentives of the various stakeholders (government, development agencies, private sector)

Project history and background:

Nepal is one of the least developed countries in the South Asian region. The country’s inflow of FDI began in the early 1980s through the gradual opening up of the economy. FDI inflow came in very slowly during the 1980s, with an annual average of $500,000. This rate saw a dramatic increase in the 1990s, following the 1990 People’s Movement, a multiparty movement that brought an end to Nepal’s absolute monarchy system in favor of a constitutional democracy. During the 1990s, FDI inflow in Nepal averaged $11 million per year. The change in government brought about more tariff rate reductions, the introduction of a duty drawback scheme, the adoption of a current account convertibility system and liberalization of the exchange rate regime. FDI inflow came to a grinding halt during the decade long Napelese Civil war which took place from 1996 until 2006. The armed conflict between the forces of the Nepal government and the Maoist fighters ended with a peace accord that ultimately resulted in the establishment of a Democratic Republic with a constituent elected governing body in 2008. Since the government has become more stable, FDI has dramatically increased in Nepal. As of January 2014, China has overtaken India to become the largest contributor of FDI to Nepal. In the 2nd half of 2013, FDI from China reached $174 million, accounting for over 60% of the country’s total FDI commitment.

Risk Measurement:

Students should understand how ADB arrived at the 7.95% discount rate. Upon some discussion, the instructor should confirm that this discount rate was obtained by inflation adjusting (1.9%) the Rupee denominated National Savings Rate Bond of Nepal (10%). The discussion should then focus on the potential deficiencies of such an approach. The project contains sovereign, operational, and reputational risks for all parties involved and the discount rate should factor in these variables. For example, does this discount rate take into account the currency exposure, expropriation risks, or environmental impact? The students should discuss the fact that ADB loan is US Dollar denominated, while the savings rate bond is Rupee denominated – therefore there is a currency risk mismatch. In addition, the students should also discuss the fact that while Nepal can print more Rupees and settle their Rupee debts, in order to settle their foreign debts, they need to tap their reserves. Therefore the default risk is different. At this point the instructor should direct the conversation towards developing a true project cost of capital.

Cost of Equity:

At this point the instructor should discuss Professor Harvey’s International Cost of Capital model. The discussion should reveal the following core risks that need to be accounted for: Currency convertibility risk, political risk, risk of expropriation, commercial international partners, and involvement of multilateral agencies, exposure to wars, and exposure to natural disasters. The following parameters were utilized for this solution, and may differ slightly based on classroom discussion:

Weights / Score / Impact on Country Premium
Sovereign
0.40 / 6.00 / -5.80 / Currency (direct, e.g. convertibility)
0.10 / 4.50 / -1.09 / Currency (indirect, e.g. political risk caused by crisis)
0.15 / -3.00 / 1.09 / Expropriation (direct, diversion, creeping)
0.05 / 6.00 / -0.73 / Commercial International partners
0.05 / 8.00 / -0.97 / Involvement of Multilateral Agencies
0.05 / -2.00 / 0.24 / Sensitivity of Project to wars, strikes, terrorism
0.05 / 0.00 / 0.00 / Sensitivity of Project to natural disasters
Operating
0.05 / 7.00 / -0.85 / Resource risk
0.03 / 0.00 / 0.00 / Technology risk
Financial
0.05 / 2.00 / -0.24 / Probability of Default
0.03 / 2.00 / -0.12 / Political Risk Insurance
Project Equity Cost of Capital / 22.64

Cost of debt:

The discussion around cost of debt should revolve around why the lenders are not requiring a market rate of return. The instructor should emphasize the involvement of development agencies as the debt lenders, who are mission driven and not just profit driven. The students should therefore analyze the project at the cost of debt as returns required by the development agencies, and as returns required by private investors if MWSDB is to solicit funding through these channels.

Subsidized cost of debt: The development agencies have granted loans for this project at 1% for the first 8 years and 1.5% for the rest of the 24 years of the 32 year loan life. Therefore the average weighted cost of debt would be 1.38%.

Market cost of debt: Since the development agencies and the GON would like to see more private sector participation, seeking debt from this channel is another area to explore. However, would the market lenders be willing to fund at such a low rate? Most likely not. Therefore the instructor should direct the conversation around how does one go about calculating the sovereign spread for Nepal in order to estimate the interest rate for a dollar denominated bond. For the purpose of this solution we have utilized the correlation between ICRG ratings and sovereign spread, as shown in the graph below.

With an estimated ICRG rating of 18.59, Nepal’s nominal sovereign spread to be 19% (figure may vary slightly), when adjusted for inflation the market interest rate on loan to Nepal is estimated to be 19.73%. The student may want to conduct additional research outside of this case to develop a better understanding of the relationship between ICRG ratings and sovereign spreads.The instructor should now ask the question to the students whether they would be willing to fund a project with such a risk level.

Weighted Average Cost of Capital

In order to calculate the cost of capital, the students must recall that the only equity holder in this project so far is the GON with 29% stake. 71% is held by ADB and its consortium as debt. The cost of capital again must be calculated in two ways – the first being the cost of capital of the project on a subsidized basis, and the second, the cost of capital to a private investors, who would not be willing to accept less returns than he/she would be able to obtain elsewhere in the global market.

Subsidized WACC: Using the WACC formula, at 29% Equity (at re=20.35%), 71% Debt (at rd=1.38%) and 0% Tax rate, the subsidized WACC comes out to 6.91% (the figure will vary depending on the previous answers calculated by the students).

Market rate WACC:Using the WACC formula, at 29% Equity (at re=20.35%), 71% Debt (at rd=19.73%) and 0% Tax rate, the subsidized WACC comes out to 19.91% (the figure will vary depending on the previous answers calculated by the students).

Value of the Subsidy

The instructor should then discuss the implications of financing a project at a heavy subsidy. As this teaching note is constructed, the value of the subsidy is calculated to be $505,049 million. This value was calculated by taking the difference between the NPV of the project at the subsidized WACC (6.91%) and the value of the project at the non-subsidized WACC (19.91%).Please refer to the valuation in the attached spreadsheet.

The discussion should highlight that in order for projects such as these to be competitive in the global market, it is not viable to keep financing projects at such heavy subsidies. There are a few discussion points that are valuable in this section:

• Value of subsidy as a data point for stakeholders: Gives an idea of how much similar projects should be subsidized if the economic conditions in the nation do not improve.
• Value of subsidy as a data point for incoming private investors: If this value is greater than $0, should the private investor be bothered to invest? Given that there are a plethora of investment opportunities in economically and competitively viable projects around the world.

IRR: The IRR for this project is calculated to be 12.5%. However at this rate a private investor with other investment opportunities would not want to invest in this project, taking into account the cost of capital to him/her is almost twice the returns. (IRR of 12.5% and WACC of 19.91%).

Students should analyze valuation results not only from IRR angle but should also consider real options that arises from completing MWSP.

Real Options

KUKL’s estimates show that the current demand of 350 MLD will be barely fulfilled by additional 170 MLD supply from MWSP. With 10% expected increase in water consumption every year, by the time MWSP is completed, Kathmandu will be in brink of another era of water shortage and KVWSB will be looking for additional funds to bring additional 170 MLD water from Rivers Larke and Yangri from Melamchi Valley in the second phase of the project. Successful completion of MWSP phase one is critical for garnering additional funding from donor agencies and private sector to complete the second phase. The expanded Melamchi project can generate up to 225 MW of hydropower and also provide irrigation to more than 30,000 hectares downstream. These provide additional revenue streams that would increase the project value. While students do not have enough data to value these potential projects, having the understanding of significance of the current MWSP project for ADB, Government of Nepal, potential private investors is critical.

What happened?

Melamchi Water Supply Development Board’s (MWDSP) spent few months in 2013 garnering support from private investors to invest in the MWSP. Despite the stable political situation in Nepal and commitment from Government of Nepal towards the project, private investors were just not attracted towards the project. As discussed in previous sections, MWDSP found it a lot easier to approach ADB for closing the funding gap. In January 2014, MWDSP proposed for additional $25 MM from ADB for tunnel construction. Both ADB and Government of Nepal would like to have private sector involvement because of potential of MSWP being a model for future investments in Nepal. However, ADB at this point in the project would rather support the project and save its reputation than waiting for private investor backing and again see project deadline being extended.

ADB approved the additional financing in February 2014. On approving the loan Fei Yue, director of the Urban Development and Water Division at the ADB’s South Asia Department said, “Once completed, the Melamchi tunnel will be a lifeline for the people of the Kathmandu valley. The tunnel will not only bring the people of Kathmandu more clean water, but also support other downstream water supply and wastewater projects in the Kathmandu valley,”. This shows real commitment from ADB towards projects in Nepal.

Sample Questions:

1. Why is the Melamchi Water Supply Project critical for ADB and other development agencies? Why is it critical for Nepal?
2. Given the Asian Development Bank and the Asian Development Fund’s focus on alleviating poverty in Asia and the Pacific region, completing the MWSP is a crucial priority. Providing clean, potable water and the necessary sanitation infrastructure are key features to improving the overall health and well-being of the Kathmandu Valley, which results in greater economic growth, sound governance, and social inclusion.
3. Nepal has a recent history of civil war, labor protests, and political turmoil and is constantly at risk of natural disasters. Strategically located between China and India, two of the largest stakeholders of the Asian Development Bank, a major political event in Nepal could significantly affect trade, natural resources, and overall security in the region. It is in the best long-term geopolitical interests of China, India, Japan, and other ADB stakeholders to support continued development in the Kathmandu Valley to ensure economic and political stability.
4. The MWSP is critical for Nepal to help support Nepal’s long-term growth. As more people move to the Kathmandu Valley for employment opportunities and foreign domestic investment enters the country, the government needs to respond to increasing strains on public utilities and domestic infrastructure. The current water access situation is a serious public health hazard and puts millions of Nepali at risk every day. Similar to the ADB’s need to support a stable political environment, Nepal is not prepared to handle more civic unrest and would do well to pursue projects that satisfy basic human needs, like water.

1. Who should the MWSDB approach for additional $25mm funding?

MWSDB should approach both the ADB and private investors for additional funding. The ADB is a default option as it has a huge reputational risk in the project and also the ADB has a better understanding of project risks and stakeholders involved. MWSDB should also reach out to private investors in order to support GON’s goals of increasing private investors’ involvement in large projects. Getting private investors on board at this stage in the project might be difficult given the time constraint for the fund requirement and relatively higher cost of equity. However, MWSDB should take a long-sighted approach in inviting private investors in the project so that it will be much easier to attract a community of private investors for MWSP phase II or other related projects.

1. What are the pros and cons looking for private funding or the ADB funding at this stage of the project?

Pros / Cons
Strong existing relationship with the ADB / Underlying problems still exist and lack of private sector engagement
Strategic geopolitical location for ADB stakeholders / Development funds could be put toward other projects
Concessionary financing from ADB / Need to stimulate sector investment
Previous lack of domestic support from private investors

1. How should an investor evaluate the economic climate in developing countries such as Nepal?

A private sector investor in a developing country such as Nepal must be aware of the sovereign, operational, and reputational risks inherent in any investment. While some of these risks can be mitigated against through contracts and covenants on financing, there are other risks that require an investor to make a calculated ‘leap of faith.’ Considering the recent country political history, increases in foreign direct investment, and record of project completion and operational success, an investor can derive an appropriate cost of capital that reflects concerns about expropriation, procurement delays, and public protest. In Nepal in particular, the support from international development agencies and the government’s continued economic reforms are attempting to foster an economic climate that is hospitable to private investors.

1. What are the risks that investors should account for while considering MWSP? What is the true project cost of capital and IRR for this project?

Answer to this is discussed in the project synopsis above.

1. As a private investor, would you invest in MWSP? Why? Why not?

Pros / Cons
•Frees up government and ADB dollars for other critical areas of economy
•Transfers risk away from public partner to private entity
•Provides diversification to investors
•Greater accountability and long-term efficiencies
•Opens the door for future private investors / •Limited number of investors willing to fund long-term projects due to illiquidity
•Private investors seek high returns for bearing risks, which may not always come to fruition
•Approval process at this stage may be lengthy

Given the heavily subsidized loans that the ADB had already provided for the project, any private sector investor would need to consider the real cost of capital and projected return on investment.

As a private investor, MWSP is still an unattractive project because of high cost of capital. Although the involvement in this project means potential for better investment opportunities in MWSP phase II or other large infrastructure projects in the country, it needs commitment from a group of private investors to attract other potential investors to the project. Additionally, given the project progress and the loan decision timeline, a private investor would have to make a quick decision on the loan. Without previous due diligence and rapport with the government and MWSP, a private investor might find this process daunting in the short amount of time.