Chapter 1: Introduction

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1.1 Introduction
The report is based on a case study of Westmoreland Energy, INC.: Power Project at
Zhangze, China. Westmoreland Energy, INC (WEI): in Charlottesville in Virginia was a
subsidiary of Westmoreland Coal Company specialized in the development of power
projects in emerging economies. The company sought to achieve long term growth
through the development of energy projects in domestic and international markets.
Dorothy Hampton was the manager of project development at WEI. She’s responsibility
was to seek out and consummate new project agreements in china. Hampton viewed
China as a means to move WEI into an attractive power market and to capitalize on
Westmoreland Coal Company’s (WCX) historic strength in coal mining in potentially
high growth coal production market. In addition to the shortage of power in the Chinese
countryside, there was also a dearth of rail and other transportation infrastructure. One
objective of the ministry of Electric Power was to encourage the development of power
projects located near the local mines. These projects would then export electricity via
high voltage transmission lines. This would lessen the burden on the railroads by
reducing the need to transport coal. Consequently, an attractive alternative to the
development of power plants in the rapidly growing coastal provinces was the
development of projects in the interior provinces.

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1.2 Origin of the Study

As an essential requirement of the course “F-601: Capital Investment Decision” offered

at the EMBA Program of Department of Finance, University of Dhaka, the case-study
on- “Westmoreland Energy, INC.: Power Project at Zhangze, China”is conducted. This
study is conducted in order to understand the application of capital investment decision
process in case of selecting a project.

1.3 Objective of the Study

 The main objective of the study is to understand the procedure of capital
budgeting and investment decision process while considering a project for future
investment.
 To get practical knowledge of business sector.
 To gather the knowledge of software analysis in case decision making process of
capital investment.

1.4 Scope of the Study

This report will help us to see the industry scenario of a country and how some factors
like- economic, political and financial factor effects on the investment decision of a
company. Because of this report we had got the opportunity to know how an investment
proposal is need to be analyzed properly before taking decision.

1.5 Methodology
This report is mainly a presentation of a case study. So, most of the data has been
provided in the case. Other than that-
 For the purpose of analysis we have taken some hypothetical assumption to have a
realistic conclusion.
 We also have taken some data from secondary sources through internet.

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1.6 Tools of Analysis
In analyzing the given case we have used financial tools like ratio, NPV, MIRR and also
used Crystal Ball Software to do a scenario analysis.

1.7 Limitations
In spite of having the wholehearted effort, there were some limitations, which acted as a
barrier to conduct the report.
 Another barrier was time constrains.
 As we are student we have knowledge bindings, we may have not analyzed data
efficiently.
 As in some cases we have taken hypothetical assumption to do our conclusion it
may have given us results which is not fully correct.

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 Chapter 2:
Case-Study Analysis

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2.1 Company Background
Westmoreland Energy Inc. in Charlottesville, Virginia was a subsidiary of Westmoreland
Coal Company. WEI was formed in 1986 to compete in the independent power and
cogeneration market. The company sought to achieve long term growth through the
development of energy projects in domestic and international markets. Its project
portfolio consisted of eight domestic projects with a gross capacity of 850 megawatts of
electricity. The company’s typical equity ownership in each of these projects was 30% to
50%. Westmoreland Coal Company was established in 1854. It held substantial coal
reserves and mining operations in the eastern United States and Montana. In recent years,
Westmoreland Coal had to contend with the oversupply and low price of Central
Appalachian Coal. Those pressures resulted in a steady consolidation and downturn
throughout the industry. Consequently Westmoreland Coal was looking to reposition
itself in new, higher growth markets. WEI’s organization comprised three operating
groups- the development group, which identified, created and managed business
opportunities. The finance and accounting group which obtained all necessary funds for
projects and supported the overall financial needs of the company. The venture and asset
management group, which oversaw the construction and operation of projects. WEI
approached each of its international markets differently.

2.2 Overview of China

China is the world's most populous country, with a continuous culture stretching back
nearly 4,000 years. Many of the elements that make up the foundation of the modern
world originated in China, including paper, gunpowder, credit banking, the compass and
paper money. China stagnated for more than two decades under the rigid Communist
rule of the founder of the People's Republic, Mao Zedong. But China now has the world's
fastest-growing economy and is undergoing what has been described as a second
industrial revolution. It has also launched an ambitious space exploration program,
involving plans to set up a space station by 2020. The People's Republic of China (PRC)
was founded in 1949 after the Communist Party defeated the previously dominant
nationalist Kuomintang in a civil war. The Kuomintang retreated to Taiwan, creating two
rival Chinese states - the PRC on the mainland and the Republic of China based on
Taiwan. The claim has in the past led to tension and threats of invasion, but since 2008
the two governments have moved towards a more cooperative atmosphere. The
leadership of Mao Zedong oversaw the often brutal implementation of a Communist

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vision of society. Millions died in the Great Leap Forward - a program of state control
over agriculture and rapid industrialization - and the Cultural Revolution, a chaotic
attempt to root out elements seen as hostile to Communist rule. However, Mao's death in
1976 ushered in a new leadership and economic reform. In the early 1980s the
government dismantled collective farming and again allowed private enterprise. The rate
of economic change has not been matched by political reform, with the Communist Party
- the world's largest political party - retaining its monopoly on power and maintaining
strict control over the people. The authorities still crack down on any signs of opposition
and send outspoken dissidents to labor camps.

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2.3 Analysis of the Economy of China

The Chinese economy experienced astonishing growth in the last few decades that
catapulted the country to become the world's second largest economy. In 1978 when
China started the program of economic reforms the country ranked ninth in nominal gross
domestic product (GDP) with USD 214 billion; 35 years later it jumped up to second
place with a nominal GDP of USD 9.2trillion. Since the introduction of the economic
reforms in 1978, China has become the world’s manufacturing hub, where the secondary
sector (comprising industry and construction) represented the largest share of GDP.
However, in recent years, China’s modernization propelled the tertiary sector and, in
2013, it became the largest category of GDP with a share of 46.1%, while the secondary
sector still accounted for a sizeable 45.0% of the country’s total output. Meanwhile, the
primary sector’s weight in GDP has shrunk dramatically since the country opened to the
world. China weathered the global economic crisis better than most other countries. In
November 2008, the State Council unveiled a CNY 4.0 trillion (USD 585 billion)
stimulus package in an attempt to shield the country from the worst effects of the
financial crisis. The massive stimulus program fueled economic growth mostly through
massive investment projects, which triggered concerns that the country could have been
building up asset bubbles, overinvestment and excess capacity in some industries. Given
the solid fiscal position of the government, the stimulus measures did not derail China’s
public finances. The global downturn and the subsequent slowdown in demand did,
however, severely affect the external sector and the current account surplus has
continuously diminished since the financial crisis. China exited the financial crisis in
good shape, with GDP growing above 9%, low inflation and a sound fiscal position.
However, the policies implemented during the crisis to foster economic growth
exacerbated the country’s macroeconomic imbalances. Particularly, the stimulus program
bolstered investment, while households’ consumption remained relatively low. In order to
tackle these imbalances, the new administration of President Xi Jinping and Premier Li
Keqiang, beginning in 2012, have unveiled economic measures aimed at promoting a
more balanced economic model at the expense of the once-sacred rapid economic
growth.

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2.4 Country Risk Analysis of China (ICRG Method)

The purpose of country risk analysis is to understand the needs of investors in regard of
an exhaustively researched analysis of the potential risks to international business
operations. Investors need a comprehensive analysis of various types of risks associated
with a country that can be measured and compared with other countries. This country risk
analysis and assessment is an integral part of capital budgeting process in the
international business community.

International Country Risk Guide (ICRG) Rating System

In this case, the assessment of the risk for the particular country (China) is based on the
International Country Risk Guide (ICRG) model for forecasting financial, political and
economic risk of the country. The International Country Risk Guide (ICRG) rating
comprises 22 variables in three subcategories of risk: political, financial and economic. A
separate index is created for each of the subcategories. The Political risk index is based
on 100 points, Financial Risk on 50 points and Economic Risk on 50 points. The risk

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ratings for these categories are then combined on the basis of a formula to provide the
country’s overall or composite risk rating. The higher the computed composite risk
rating, the lower the risk and vice versa.

i. Political Risk Rating of China

The aim of political risk rating is to provide a means of assessing the political stability of
the country. Risk points are assigned to a pre-determined set of 15 factors. The minimum
number of points that can be assigned to each component is zero, while the maximum
number of points depends on the fixed weight of the component. In every case, the lower
the risk point total, the higher the risk and vice versa.

Component Points Given

Government 5
Stability
Socioeconomic 5
Conditions
Investment Profile 7
Internal Conflict 6
External Conflicts 6
Corruption 4
Military in Politics 3
Religious Tensions 4
Law and Order 4
Ethnic Tensions 4
Democratic 2
Accountability
Bureaucracy Quality 2
Total 52

Assessing Political Risk

A political risk rating of 0%-49% indicates a very high risk, 50%-59% high risk, 60%-
69% moderate risk, 70%-79% low risk and 80%-above very low risk. In our assessment,
China’s political risk rating is 52%, which means that China has a high political risk.
However, a poor political risk rating can be compensated by a better financial and
economic risk rating.

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 ii. Economic Risk Rating of China
The aim of economic risk rating is to provide a means of assessing a country’s current
economic strengths and weaknesses. In general terms, the strengths and weaknesses are
assessed by assigning risk points to a set of pre-determined subcomponents.

Components Points Assigned

GDP Per Head 5.0
Real GDP Growth 9.0
Annual Inflation Rate 4.5
Budget balance as 6.5
Percentage of GDP
Current Account as a 9.5
Percentage of GDP
Total 34.5

Assessing Economic Risk

Overall, an economic risk rating of 0%-24.5% indicates a Very High Risk, 25%-29%
High Risk, 30%-34.9% Moderate Risk, 35%-39.9% Low Risk and 40% or more Very
Low Risk. According to this risk rating, the economic risk of China is termed as High
Risk.

iii. Financial Risk Rating of China

The aim of the financial risk rating is to provide a means of measuring a country’s ability
to finance its official, commercial and trade debt obligations. This is done by assessing
risk points to a pre-set group of factors termed as financial risk components. In every
case, the lower the risk point total, the higher the risk and the higher the risk point total
the lower the risk.

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Component Point Assigned
Foreign Debt as a Percentage of GDP 9.5
Foreign Debt as a Percentage of Export of 9.5
Goods and Services
Current Account as a percentage of Export 9.5
of Goods and Services
Net International Liquidity as Months of 4.0
Import Cover
Exchange Rate Stability 8.0
Total 40.5

Assessing Financial Risk

A financial risk rating of 0%-24.5% indicates a Very High Risk, 25%-29.9% High Risk,
30-34.9% moderate Risk, 35%-39.9% Low Risk and 40% or more Very Low Risk. As for
China, the country represents a very low financial risk.

Composite Risk Rating

The composite political, financial and economic risk rating represents a country’s overall
risk assessment and the aggregate risk is calculated using the following formula:

Total Value of Political Risk 52.0

Total Value of Financial Risk 34.5
Total Value of Economic Risk 40.5
The highest overall rating (100) indicates the lowest risk and the lowest rating (0)
indicate the highest risk.

Composite
Indicating
Risk .5*(PR+FR+ER)
63.5 Moderate
Rating of =.5*(52+34.5+40.5)
Risk
China

So, the overall composite risk rating of China indicates a Moderate Risk.

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2.5 Analysis of Industry: PESTEL Analysis

PEST is an acronym for Political, Economic, Social and Technological. This analysis is
used to assess these four external factors in relation to your business situation. PESTLE
analysis, which is sometimes referred as PEST analysis, is a concept in marketing
principles. Moreover, this concept is used as a tool by companies to track the
environment they’re operating in or are planning to launch a new project/product/service
etc.

PESTEL is a mnemonic which in its expanded form denotes P for Political, E for
Economic, S for Social, T for Technological, L for Legal and E for Environmental. It
gives a bird’s eye view of the whole environment from many different angles that one
wants to check and keep a track of while contemplating on a certain idea/plan.

i. POLITICAL
 Stability of government was shaky in China
 Instability in China’s top political leadership could change attitude towards
foreign investment.
 Global relations were under cloud of uncertainty due to China’s communist
ideology.
 Potential changes to legislation might have unfavorable results.
 No payment delay by government.
 No civil war or cross-border conflict.
 Little foreign pressure.
 Little corruption and terrorism.

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 ii. ECONOMIC
 Unemployment rate was moderate. It was 4.33% in 1994
 Poverty level was 92.51%
 Consumer confidence was high.
 Inflation was high 5%-26%
 Per head GDP was very high.

iii. SOCIAL

 Lifestyle was moderately high.

 Income was well distributed.

iv. TECHNOLOGY

 International influences were present.

 There were changes in information technology.

v. ENVIROMENTAL

 Attitudes of local people were good as there were high demand of power
sector.
 Local and provincial supports assist the project in gaining necessary
approvals and funding.

vi. LEGAL

 Legal system was a civil law system based on written status.

 No well-developed body of laws existed.
 New laws and changes to existing laws might adversely affect foreign
investment.
 The legal system might impede the development of competitive markets
and development of roles and responsibilities of players in those markets.

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2.6 Analysis of the Company
2.6.1 Ratio Analysis:
A ratio analysis is a quantitative analysis of information contained in a company’s
financial statements. Ratio analysis is based on line items in financial statements like
the balance sheet, income statement and cash flow statement; the ratios of one item – or a
combination of items - to another item or combination are then calculated.

Here, Ratio analysis is used to evaluate various aspects of a WEIs operating and financial
performance such as its efficiency, liquidity, profitability and solvency. The trend of
these ratios over time will be studied to check whether they are improving or
deteriorating. Again we will use this ratio results to interpret the business and financial
risk Associated with this company for running this project in China.

Ratios Related With Business Risk Ratios Related With Financial Risk

Gross Profit Margin

Net Profit Margin
Return on Equity
Return on Investment Debt Coverage Equity
Return on Asset Interest coverage Ratio
Contribution Margin Debt equity ratio
Operating Leverage Effect
Financial Leverage Effect
Total Leverage Effect

1. Gross Profit Margin:

Gross profit margin is a financial metric used to assess a company's financial health and
business model by revealing the proportion of money left over from revenues after
accounting for the cost of goods sold (COGS). Gross profit margin, also known as gross
margin.

Formula:

Gross Profit
Sales
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Now, WEI is going to generate gross profit in for Eight year from the project is given
below

1998 1999 2000 2001 2002 2003 2004 2005

0.7906 0.793441 0.792261 0.790616 0.789098 0.787129 0.785249 0.783441

Interpretation:

Ratio of gross profit margin shows that it will be same over eight years which will be a
problem with the passage of time as our discounting will be higher for the later years.

2. Net Profit Margin:

Net profit margin is the ratio of net profits to revenues for a company or business
segment. Typically expressed as a percentage, net profit margins show how much of each
dollar collected by a company as revenue translates into profit.

Formula:

Net Profit
Sales

1998 1999 2000 2001 2002 2003 2004 2005

0.0369 0.145519 0.159979 0.194597 0.229676 0.2166 0.244667 0.273261

Interpretation:

The results are shown above of net profit margin ratios which shows that the projects
ability to convert revenue to sales per dollar is continuously increasing which is a good
sign but it at the 8th year will be 27.32% is a matter of concern as other things like Cost of
debt can be higher than this.

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 3. Degree of Operating Leverage:

The degree of operating leverage (DOL) is a leverage ratio that summarizes the effect a
particular amount of operating leverage has on a company's earnings before interest and
taxes (EBIT) over a period of time. Operating leverage involves using a large proportion
of fixed costs to variable costs in the operations of the company.

Formula

Change In EBIT
Change in Sales

1998 1999 2000 2001 2002 2003 2004 2005

0.7339 0.613719 0.590478 0.592271 0.564353 0.567855 0.566869 0.47727

Interpretations:

The DOL ratio shows that the project is highly leveraged and this is the reason behind
continuous decreasing DOL as we are paying more debt as the years passes by. To make
it more stable project manager should check other sources of cheap cost financing.

4. Degree of Financial Leverage:

A ratio that measures the sensitivity of a company’s earnings per share (EPS) to
fluctuations in its operating income, as a result of changes in its capital structure. Degree
of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in
earnings before interest and taxes (EBIT), and can be mathematically represented as
follows .

Formula:

EBIT
EBIT-Interest

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 1998 1999 2000 2001 2002 2003 2004 2005
1 1 1.062292 1.07604 1.08969 1.231343 1.266567 1.302653

Interpretation:

We can see that the earnings before interest and tax are near about triple for the first year
and gradually it becomes double to EBT which indicates that we are using a very high
interest for collecting our fund.

5. Degree of Total Leverage:

By combining the degree of operating leverage with the degree of financial leverage we
obtain the degree of total leverage (DTL). If a firm has a high amount of operating
leverage and financial leverage, a small change in sales will lead to a large variability in
EPS.

Formula:

OLE × FLE

1998 1999 2000 2001 2002 2003 2004 2005

0.7339 0.613719 0.62726 0.637307 0.61497 0.699224 0.717978 0.621717

Interpretation:

DTL shows that for the prior years the DTL is very higher due to its higher DOL and
DFL and it is fluctuating.

6. Return on Equity:

ROE is a ratio that provides investors with insight into how efficiently a company (or
more specifically, its management team) is managing the equity that shareholders have
contributed to the company.

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Formula:

Net Income
Total Equity

In case of WEI we can see that-

1998 1999 2000 2001 2002 2003 2004 2005

44.806 55.53135 58.64476 61.64026 64.85948 67.92694 71.21921 74.71118

Interpretation:

The project needs more financing and this should be done through issuing shares in the
market because the convertibility of equity to income or generation of income is much
higher.

7. Return on Asset:

Return on assets (ROA) is an indicator of how profitable a company is relative to its total
assets. ROA gives an idea as to how efficient management is at using its assets to
generate earnings. Calculated by dividing a company's annual earnings by its total assets.

Formula:

Net Income
Total Asset

1998 1999 2000 2001 2002 2003 2004 2005

8.7361 10.82731 11.43436 12.01841 12.64608 13.24416 13.88608 14.56693

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Interpretation:

We can see that projects income and assets are gradually going up and that’s make the
ROA at last year to 14% which indicates that the project can convert its 100 dollar asset
to 114 dollar.

8. Return on Investment:

Return on investment or ROI is a profitability ratio that calculates the profits of an

investment as a percentage of the original cost. In other words, it measures how much
money was made on the investment as a percentage of the purchase price. It shows
investors how efficiently each dollar invested in a project is at producing a profit.
Investors not only use this ratio to measure how well an investment performed, they also
use it to compare the performance of different investments of all types and sizes.

Formula:

Net Profit
Investment

1998 1999 2000 2001 2002 2003 2004 2005

11.201 13.88284 14.66119 15.41007 16.21487 16.98174 17.8048 18.67779

Interpretation:

Ratio shows that per dollar invested in the project will give benefit of 19 that means that
this is the total amount we are getting from our investment so it is a good project to invest
only if we can finance it.

9. Equity Multiplier:

The equity multiplier is a straightforward ratio used to measure a company’s financial

leverage. The ratio is calculated by dividing total assets by total equity.

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When a company purchases major assets, it can finance those purchases by incurring debt
or issuing stock. A high equity multiplier indicates the company has been using more
debt than equity to finance its asset purchases.

Formula:

Total Asset
Equity

1998 1999 2000 2001 2002 2003 2004 2005

512.88 512.8821 512.8821 512.8821 512.8821 512.8821 512.8821 512.8821

Interpretation:

These ratios clearly indicate that the project uses more debt than equity for financing.

10. Debt to Capital Ratio:

The debt-to-capital ratio is a measurement of a company's financial leverage. The debt-

to-capital ratio is calculated by taking the company's debt, including both short- and long-
term liabilities and dividing it by the total capital. Total capital is all debt
plus shareholders' equity, which may include items such as common stock, preferred
stock and minority interest.

Formula:

Total Debt
Total Capital

=75

Interpretation:

The condition of debt is continuously decreasing in the project as we are repaying it

continuously and at the 7th year it becomes 0 which is good sign to invest.

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 11. Debt to Equity Ratio:

Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage,

calculated by dividing a company’s total liabilities by its stockholders' equity. The D/E
ratio indicates how much debt a company is using to finance its assets relative to the
amount of value represented in shareholders’ equity.

Formula:

Total Debt
Total Equity

= 3.25

Interpretation

The debt of the company is continuously decreasing that makes the D/E ratio 0 at the 7 th
year which is a good sign as risk of the project is lessen down but in future it is going to
face the liquidity crisis so to avoid the crisis the project needs either more fund and which
can be available either from debt instruments or from equity.

12. Time Interest Earned Ratio:

The interest coverage ratio is a debt ratio and profitability ratio used to determine how
easily a company can pay interest on outstanding debt. The interest coverage ratio may be
calculated by dividing a company's earnings before interest and taxes (EBIT) during a
given period by the amount a company must pay in interest on its debts during the same
period.

Formula:

EBIT
Interest

1998 1999 2000 2001 2002 2003 2004 2005

1.84 2.4 2.5 2.83 3.26 3.87 4.78 6.28

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Interpretation:

As this ratio is going to show the easiness of interest payment on the EBIT and as the
result is continuously going higher shows that the project will be a risky one to invest
because it will be difficult to maintain that easiness of repayment.

13. CFO to Debt Ratio:

It compares a company's operating cash flow to its total debt, which, for purposes of this
ratio, is defined as the sum of short-term borrowings, the current portion of long-term
debt and long-term debt. This ratio provides an indication of a company's ability to cover
total debt with its yearly cash flow from operations. The higher the percentage ratio, the
better the company's ability to carry its total debt.

Formula:

Cash Flow From

Operation
Total Debt

1998 1999 2000 2001 2002 2003 2004 2005

0.0257 0.058546 0.062715 0.077722 0.097615 0.09657 0.129032 0.193269

Interpretation:

The scenario of the project shows that the debt becomes zero that’s why the result is
continuously decreasing and the company needs more financing to run in future or have
to stop operation.

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2.6.2 DuPont Analysis:
According to DuPont analysis, ROE is affected by three things: operating efficiency,
which is measured by profit margin; asset use efficiency, which is measured by total asset
turnover; and financial leverage, which is measured by the equity multiplier.

Formula:

ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier

1998 1999 2000 2001 2002 2003 2004 2005

3.8234 17.08157 19.55087 24.71886 30.36166 29.75009 34.95284 40.63913

Interpretation:

It’s basically the ROE which we get from Net profits divides by Equity. It shows that the
equity investment can make the project more out bursting than the debt instruments.

Extended DuPont Analysis:

The Extended DuPont provides an additional decomposition of the Profit Margin Ratio
(Net Income/Sales) into two burden components, Tax and Interest, times the Operating
Profit Margin. This is a positive refinement of the traditional DuPont Analysis to provide
a refinement of the profit margin ratio into the operating profit margin ratio by taking out
the effects arising from taxes and interest expense. As a result, it provides both
management and the financial analyst with finer information about a company and its
immediate competitors.

Formula:

ROE = (Net Income/EBT) * (EBT/EBIT) * (EBIT/Sales) * (Sales/Total Assets) *

(Total Assets/Shareholders’ Equity)

1998 1999 2000 2001 2002 2003 2004 2005

3.8234 17.08157 19.55087 24.71886 30.36166 29.75009 34.95284 40.63913

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Interpretation

Extended DuPont analysis is done to make the effects of profit margin, total asset turn
over and equity multiplier more clear and in this situation which indicates us that the
ROE , DuPont and Extended DuPont is giving exactly the same value.

2.6.3 Business Risk Analysis

Business risk is the possibilities a company will have lower than anticipated profits or
experience a loss rather than taking a profit. Business risk is influenced by numerous
factors, including sales volume, per-unit price, input costs, competition, and the overall
economic climate and government regulations. A company with a higher business risk
should choose a capital structure that has a lower debt ratio to ensure it can meet its
financial obligations at all times. The company is also exposed to financial risk, liquidity
risk, systematic risk, exchange-rate risk and country-specific risk. This makes it
increasingly important to minimize business risk. To calculate the risk, analysts use four
simple ratios: contribution margin, operation leverage effect, financial leverage effect and
total leverage effect.

In the project we are facing two kinds of business risk among them one is related with
compliance and the other is with operations. The First business risk is compliance risk.
This type of risk arises in industries and sectors highly regulated with laws. And the
project is facing some compliance risk due to new changes made by the new Govt.

The other risk related to our project is operational risk under the segment of business risk.
This risk arises when the day-to-day operations of a company fail to perform. Due to
higher interest payment or the debt is too much higher that makes operational risk for the
company. If we see the ratios than we can see that the DOL of the company in 1998 is
73.33% and it’s going down day by day and implication of it is that our leverage is lessen
down.

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2.6.4 Financial Risk Analysis

Financial risk is the possibility that shareholders will lose money when they invest in a
company that has debt, if the company's cash flow proves inadequate to meet its financial
obligations. When a company uses debt financing, its creditors are repaid before its
shareholders if the company becomes insolvent. Financial risk also refers to the
possibility of a corporation or government defaulting on its bonds, which would cause
those bondholders to lose money. The term is typically used to reflect an investor's
uncertainty of collecting returns and the potential for monetary loss. Investors can use a
number of financial risk ratios to assess an investment's prospects. For example, the debt-
to-capital ratio measures the proportion of debt used, given the total capital structure of
the company here which is 75% which indicates a highest risk for the investor to invest in
such a project that’s why he will ask for more premium. Another ratio, the capital
expenditure ratio, divides cash flow from operations by capital expenditures to see how
much money a company will have left to keep the business running after it services its
debt here which is very low as after giving or paying 3655millions loan and other
expenses the company will left a very little amount to operate which will make project a
less survival one.

2.6.5 SWOT Analysis:

SWOTanalysis (alternatively SWOTmatrix)is acronyms for strengths, weaknesses, opp

ortunities,and threats and is a structured planning method that evaluates those four
elements of an organization, project or business venture. A SWOT analysis can be carried
out for a company, product, place, industry, or person. It involves specifying the
objective of the business venture or project and identifying the internal and external
factors that are favorable and unfavorable to achieve that objective.

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STRENGTHS

1. The project was an Extension project of existing plant .Ideally that would translate
into a shorter development period and lower development cost.
2. Local and provincial support and high degree of government support would assist
the project in gaining approvals and funding.
3. All the power generated by the project would be purchased by Shanxi Provincial
Electric Power Company.
4. It was a well-established plant of conventional size and it would use proven
technology
5. The Shanxi Power Bureau had indicated a desire for the project to be operational
in 1998.This would provide high visibility and early foothold in China for WEI.

WEAKNESSES

1. A key potential investor had backed away from the deal and decision making on
the part of Chinese was agonizingly slow.
2. Higher fixed cost
3. High corporate tax rate.

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OPPURTUNITIES

1. China was the most populous country on earth but compared to other developing
countries China’s power sector was vastly underdeveloped.
2. Increasing demand for electricity and a huge market.

THREATS

1. Increasing variable costs escalated by inflation.

2. Strict regulations of the government
3. Currency fluctuations
4. Involvement of private and non-Chinese parties in more than 70,000MW worth
of projects.

2.7 Problem Statement

In the case we have found the problem that should Westmoreland Energy INC run the project
with existing terms like capital structure and what amount of discount rate they should use.

2.8 Alternative Course of Action:

 Debt Financing at cheaper Rate
 Increasing the Equity through Equity Financing.

2.9 Analyzing the Project

At this part we will calculate the cost of capital, Net Present value, Internal Rate of Return,
Modified Rate of Return and then we will run the Monte Carlo stimulation process to measure
the stand alone risk Associated with the project.

2.9.1 Assessing the Discount rate:

According to CAPM Approach:

i) Cost of Equity:
Real Risk Free Rate, Rf= 5%
Market Risk Premium, Rm= 7.0%
Comparable Asset beta= 0.45
Country Beta of China Relative to U.S= 1.08

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 Cost of Equity, Ks= Risk-Free Rate+ Market Risk Premium*Project Beta

Project Beta= Comparable Asset beta* Country Beta of China

=0.45*1.08=0.486
Cost of Equity, Ks= 0.05 + 0.07 (0.45*1.08) = 0.08402
ii) Cost of Debt:

a) After tax cost of Chinese debt, KD= Kd(1-T) =0.12(1-0.30)=0.084

b) After tax cost of US loan, KD= Kd(1-T)= 0.11(1-0.30)= 0.077

WACC Calculation:

Capital Amount (CNY) Weight Component Weight*Cost

component Cost
Debt from 1005.82 .209988 .084 .01763899
China
Debt from US 2647.74 .552776 .077 .04256375
WEI Equity 1136.34 .237237 .08402 .01993265
Total 4789.9 .08013539

WACC= 0.08013539

The risk adjusted cost of capital = WACC+ Additional Risk Premium+ Country Risk
Premium = 0.08013539 +0.02+ 0.02= 0.12013

Assuming, inflation rate=5%

The inflation adjusted discount rate= (1+0.12013) (1+0.05)-1=0.17613

So, the inflation adjusted discount rate is 17.61%

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2.9.2 Result of Traditional NPV, IRR & MIRR:

Now, at 17.61% cost of capital and the result of NPV, IRR and MIRR for this project is:

NPV 379.74
(Million
CNY)
IRR 19%

MIRR 14%

In terms of this result we can say that, Westmoreland Energy Inc. should invest in this
project as its NPV is positive and also its IRR is more than cost of capital.

2.9.3 Standalone risk Analysis of the project through Monte Carlo Stimulation:

Standalone risk measures the dangers associated with a single facet of a company's
operations or by holding a specific asset. In portfolio management, standalone risk
measures the undiversified risk of an individual asset. For a company, standalone risk
allows them to determine a project's risk as if it were operating as an independent entity.
There are various method to measure the risk associated with a particular project of a
company. One of the very popular method is Monte Carlo stimulation analysis.

Monte Carlo simulations are used to model the probability of different outcomes in a
process that cannot easily be predicted due to the intervention of random variables. In our
case we have used crystal ball software to analyze the sensitivity of this project. We have
taken various components of this project such as- sales price, variable cost, fixed cost,
equity investment by the project which helped to forecast the certainty level of net
present value by running the stimulation for 10000 times.

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31 | P a g e
Interpretation:

From the above analysis also showing that from this project the company is going to
generate profit.

2.9.4 Scenario Analysis of the Project:

Standalone risk of a project also can be measure through the scenario analysis. Scenario
analysis is the process of estimating the expected value of a portfolio after a given period
of time, assuming specific changes in the values of the portfolio's securities or key factors
take place, such as a change in the interest rate. Scenario analysis is commonly used to
estimate changes to a portfolio's value is response to an unfavorable event, and may be
used to examine a theoretical worst-case scenario.

In calculating the scenario analysis of the project we have used some hypothetical
probability to calculate the certain cash flow level in each year. Then we have calculate
the expected return, standard Deviation and covariance of the cash flows to estimate the
risk.

The results are given below:

Scenario net cash Expected

(Ei-Ē) (Ei-Ē)^2
year flow probability Return (Ei)
More than
worst 1998 88 0.011 0.968 -734.782 539904.5875
Worst 1999 186 0.023 4.278 -731.472 535051.2868
Worst 2000 182 0.022 4.004 -731.746 535452.2085
Bad 2001 202 0.025 5.05 -730.7 533922.49
Bad 2002 221 0.027 5.967 -729.783 532583.2271
Worst 2003 183 0.022 4.026 -731.724 535420.0122
Worst 2004 192 0.023 4.416 -731.334 534849.4196
Bad 2005 201 0.025 5.025 -730.725 533959.0256
Bad 2006 209 0.026 5.434 -730.316 533361.4599
Bad 2007 216 0.027 5.832 -729.918 532780.2867
Good 2008 824 0.101 83.224 -652.526 425790.1807
Good 2009 847 0.104 88.088 -647.662 419466.0662
Good 2010 871 0.106 92.326 -643.424 413994.4438
Good 2011 895 0.11 98.45 -637.3 406151.29
Best 2012 919 0.113 103.847 -631.903 399301.4014
Best 2013 944 0.116 109.504 -626.246 392184.0525
Best 2014 969 0.119 115.311 -620.439 384944.5527
Ē 735.75 8189115.991
 2861.663151

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 
3.889450426 Indicating high risk project in terms of cash flow
CV
analysis in each year
Ē

From this results we can also see that this project is indicating very high risk for the
company. As the co-variance is almost 3.88 which is greater than 1.

2.9.5 Analysis of Real Option Value

Dorothy Hampton was thinking to provide the equity fund from the parent company in
the upcoming years. As there is inflation, she needs to invest more than she estimated in
earlier times. The cost of this project is 540 million $in CNY 4752 but it needed 1137
CNY in first 3 years for inflation or other reasons. She expects that the investment can be
realized in 7 years. Discount rate is 17.61% and risk free rate is 5%. The new firm can
exercise the real option within next 4 years. Net cash flow each year due to the new
product is estimated as follows:

Calculation of Present Value of the Project:

Here, Discount rate, i= 17.61%

Year, n= 17 years.

Annuity factor:

[(1-1/ (1+.1761)17)/.1761 ]

= 5.31827

Cost=1137 CNY

S= 3912.917153

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 PV of Expected
Year Cashflow Cashflow Probability Return Return
1998 88 468.00776 0.011 -0.59 -0.01 0.0037248303676
1999 186 989.19822 0.023 -0.13 0.00 0.0003709841566
2000 182 967.92514 0.022 -0.15 0.00 0.0004653048014
2001 202 1074.29054 0.025 -0.06 0.00 0.0000722926979
2002 221 1175.33767 0.027 0.03 0.00 0.0000290616284
2003 183 973.24341 0.022 -0.14 0.00 0.0004364927488
2004 192 1021.10784 0.023 -0.10 0.00 0.0002280888989
2005 201 1068.97227 0.025 -0.06 0.00 0.0000850746693
2006 209 1111.51843 0.026 -0.02 0.00 0.0000123886133
2007 216 1148.74632 0.027 0.01 0.00 0.0000027281747
2008 824 4382.25448 0.101 2.85 0.29 0.6649934139830
2009 847 4504.57469 0.104 2.96 0.31 0.7324245667337
2010 871 4632.21317 0.106 3.07 0.33 0.8005847437076
2011 895 4759.85165 0.11 3.19 0.35 0.8846120899110
2012 919 4887.49013 0.113 3.30 0.37 0.9673436999175
2013 944 5020.44688 0.116 3.42 0.40 1.0574901428372
2014 969 5153.40363 0.119 3.53 0.42 1.1525308277662
2.44 6.2654067316130

Standard Deviation Calculation

σ = Σ √(probability ∗ (return − expected return)^2)

=2.50307945
Now,

S= 3912.917153

X=1137

r =5%

σ= 2.50307945

t= 4
𝐥𝐧(𝐒/𝐗) + (𝐫+ 𝛔^𝟐 /𝟐)∗𝐭
d1=
𝛔∗√𝒕

= 1.204545989

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d2=d1- 𝛔 ∗ √𝒕

= -3.80161291

Area of normal curve for d1, N (d1) = 0.885810691

Area of normal curve for d2, N (d2) = 7.18786E-05

According to Black-Scholes model,

C= S*N (d1)-X*𝒆−𝒓∗𝒕 *N (d2)

=3466.039557

Here, we can see if Westmoreland Energy Inc. is going to exercise the real option it will
generate positive value for the company. From that we can calculate the true NPV for the
project. That is:

True NPV = Value of NPV from the traditional Project + Real Option Value

So, true NPV for this project is-

= 379.74 + 3466.039557

= 3845.779557

In each of the alternative analysis we can see that this project got worth of investment as
has positive NPV that means it will generate profit for WEI.

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Chapter 3: Recommendations
&Conclusion

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Westmoreland Energy Inc. should do the investment in China to set up the project. In
every analysis that we have done to interpret the feasibility of the project has showing
Positive results but there are some problems we have got during this analysis-

Problems

 Country risk is moderate but when we did the scenario analysis it resulted in high
risk by using the same discount rate.
 Secondly, the inflation rate was high during the equity investment. For that they
had to finance more amount than the estimation.
 A key investor had backed away from the investment.
Solution:

 Dorothy Hampton needed to report to her boss that they should negotiate with
Chinese government about the capital structure ratio.
 They should mainly manage large portion of debt from US at a cheaper rate.
 As their recovery period is more than 7years, they should focus on the sales to
increase the net cash inflow.

3.2 Conclusion:
This report is based on a case Study on- “Westmoreland Energy INC.; Power Project in
China”. Where the company wanted to set up a project of electric power generation at
Zhangze in China. We have done analysis thorough financial and statistical to get in to a
conclusion that Dorothy Hampton the Manager of the project, should push forward the
project on its own or not. To get the answer we have done some financial ratio analysis to
determine the business and financial risk associated with it, we have done the country
risk analysis to know whether to adjust risk premium in the cost of capital or not. We
have also done PESTEL analysis to analyze the industry of the automobile where the
company is going to sell its product. We have also calculated NPV, MIRR, IRR through
Monte Carlo stimulation, real option through a hypothetical analysis and so on. At the
end of our analysis we have concluded that the company should invest its money in this
project as its true NPV is positive but should keep in focus the scenario analysis as it is in
high risk and recovery period is also high. At last, we want to mention that as we are just
student and still learning, that’s why we have interpret something in a wrong way. In
spite of that we have tried our best to prepare this report as accurately as possible.

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