1. Background
The water supply systems in some regions of Azerbaijan, like Balakan, Beylagan and Agjabedi, are in a state of collapse due to insufficient maintenance, ageing and corrosion. The inhabitants of those areas can only rely on wells and private vendors for their daily water requirements.
HAYATSU, the Republic of Azerbaijan’s National Water Supply Company, is a joint-stock company that specializes in water supply and sanitation. HAYATSU, in collaboration with the Asian Development Bank, is planning to implement a Water Supply Project in Balakan. When completed, the project will replace all the private vendors who are currently charging 3 LC/m3 for water delivered. The private vendors raise their prices regularly to keep up with the rate of inflation. In addition, the project is expected to have significant positive and environmental impacts.
The construction of the water supply system will start in Year 1 and will be completed in two phases:
Phase 1: Reconstruction of the Water System
Phase 2: Installation of Water Meters
The duration of construction will be one year. The project operations will commence in Year 2 with the supply of water to areas in and around the city of Balakan. For the purposes of analyzing this project, it is assumed that the project will operate for 20 years, from Year 2 to Year 21. The project will be liquidated in Year 22. The Planning Division of HAYATSU has prepared a project report which includes the details on the sources of financing and a description of the project. The essential details of this report that are pertinent to the analysis are summarized in the subsequent sections.
2. Water Tariffs
Once the water supply project becomes operational, HAYATSU will charge a water tariff of 0.39 LC per m3 (Year 1 prices) for residential consumers and 1.04 LC per m3 (Year 1 prices)for businesses and government institutions. It is assumed that the water tariff in the following years will be indexed to the domestic rate of inflation. The water tariff is subject to a VAT of 18%.
3. Water Demand and Supply
The residential population of Balakan as of Year 1 is 20,357, and it is expected to rise by a rate of 1.5% per annum. HAYATSU is anticipated to entirely satisfy the water needs of the city of Balakan.
The average demand for water from residential consumers is estimated to be approximately 210 liters per person per day.
The demand for water for non-residential is assumed to be 550,000 m3 in Year 1. It is expected that the annual growth rate for non-residential demand for water will be 1.5%. The breakdown of demand by non-residential consumers is assumed to be as follows:
- Commercial & Industrial consumers’ demand (57% of non-residential)
- Government Institutions’ demand (43% of non-residential)
The population of Balakan as of Year 1 is 20,357, and it is expected to rise by a rate of 1.5% per annum. HAYATSU is anticipated to entirely satisfy the water needs of the city of Balakan.
4. Capital Expenditure
Land: No capital expenditures for land are necessary. Since the water pipes will be buried.
Equipment: All equipment’s are imported. The CIF cost of all equipment is USD 9.373 million (in Year 1 prices). This amount includes the cost of water receivers, main water pipeline, collectors, the main intercity distribution network, water reservoirs, hydraulic equipment measuring devices, chlorinator, water stations and water meters. All the equipment will be imported and installed in Year 1. Imports are subject to a 15% import duty on the CIF price. The prices of all imports, including equipment, are expected to rise at the rate of foreign inflation. Total capital expenditure on equipment will be incurred in Year 1.
Establishment and Support Services: The total capital expenditure on establishment and support services amounts to USD 1.188 million (in Year 1 prices). The cost of establishment and support services includes the cost of drilling, digging and other earthworks, installation of pipes, repair of asphalt surfaces, construction works and water use evaluations. Total capital expenditure on this component will be incurred in Year 1.
5. Residual Values
The straight-line depreciation method is used in determining the economic depreciation of the project’s assets as well as their residual values. The economic life of the project’s equipment (which includes establishment and support services) is assumed to be 25 years, assuming no major capital replacements for the duration of the project.
6. Tax Depreciation
All of the project’s equipment is to be depreciated for tax purposes using the straight-line method. For tax purposes, the project’s equipment (which includes establishment and support services) is assumed to have a useful life of 20 years. The depreciation allowances are calculated on the basis of the sum of the historical cost of the assets for the years during which the capital expenditure was incurred.
7. Operating Expenditure
Chemicals: Chemicals (coagulants, polymers and chlorine) are needed to clean the water supply system. These items are manufactured locally and considered to non-traded goods. The financial cost of chemicals is assumed to be 76,680 LC per annum (in Year 1 prices). The costs are subject to a VAT of 18%. The cost of chemicals is expected to rise at the general rate of domestic inflation.
Labor: The Project will employ two types of labor from the local labor market:
- Skilled Labor: 20 engineers will be employed. The engineers’ monthly wage is 510 LC (in Year 1 prices), and this wage is expected to grow in real terms by two percent per annum. Additionally, the wage will be indexed to the domestic rate of inflation.
- Unskilled Labor: 20 unskilled laborers will be employed, their monthly wage is 153 LC (in Year 1 prices), and it is expected to grow in real terms by two percent per annum. Additionally, the wage will be indexed to the domestic rate of inflation.
Electricity: Electricity will be utilized to pump water and distribute it to various users in the water supply network. The water supply system’s daily electricity requirement is assumed to be 3,120 kWh. The price of electricity per kWh is 0.0648 LC (in Year 1 prices), and it is expected to increase at the general rate of domestic inflation. Electricity charges are also subject to a VAT of 18%.
Other Costs: Other miscellaneous costs of operating the water supply system are anticipated to be about 5% of the total cost of chemicals, labor and electricity costs (VAT Exclusive). Other costs are also subject to a VAT of 18%.
8. Working Capital
Account’s receivables are expected to amount to approximately 15% of Gross Sales. No accounts receivables are expected to be outstanding for more than 12 months.
Accounts payable are expected to amount to 10% of total operating expenditure, excluding labor costs. The company will not allow any accounts to remain unpaid for more than 12 months.
For operational purposes, the water utility will maintain a cash reserve equal to 5% of the value of total operating expenditure.
9. Project Financing
The water supply project will be funded through a blend of debt and equity. Debt and equity financing will account for 70% and 30% of capital expenditure, respectively. The debt financing will be provided by the Asian Development Bank (ADB), while the equity funding will come from the Government of Azerbaijan.
The terms of ADB’s loan facility are as follows:
- A real rate of interest charged by the ADB on a foreign currency loan is 1.5%. The nominal rate of interest charged is the real rate adjusted for the expected rate of foreign inflation.
- A grace period for principal payments lasts until the end of Year 6.
- The loan principal is paid in twelve equal annual installments, starting from year 7
- The interest expense that is accrued in Year 1 will be paid in Year 2 and interest expense that is accrued in Year 2 will be paid in Year 3 etc.
10. Corporate Taxes
The project will be subject to corporate income tax. The tax law allows a full deduction of the operating expenditures, interest expense and depreciation allowances. The rate of corporate income tax is 22% of taxable income.
11. Discount Rate
The equity holder’s real required rate of return is 10%.
12. Exchange Rates and Inflation
Exchange Rates: The real exchange rate of 0.8 LC per USD (in Year 1 prices) is assumed to remain constant during the life of the project. The projected nominal exchange rates in the following years is the real exchange rate adjusted by the relative price index between the domestic and foreign currency.
Inflation: In Year 1, the Domestic and foreign inflation rates are 8% and 3% respectively. Both inflation rates are assumed to remain constant during the life of the project.
Financial and Sensitivity Analysis Assignments:
Assignment 1:
A financial model template has been provided to you, which you should use to assess the feasibility of undertaking the Hayatsu Water Supply project. You should complete the model for you to be able to make a holistic assessment of the investment potential of the proposed project.
You should complete the following modules in your financial model:
- Inputs Module: you should enter all of the assumptions, data and parameters necessary to compute the key components of the project; such as project costs, financing and revenues. All the information you require for this module has been provided in the preceding sections of this handout.
- Calculations Module: utilizing the information you entered into the input’s module, you are to complete the following sections of the calculation’s module
- Inflation, prices indices, exchange rates and interest rates
- Capital expenditure
- Economic depreciation and residual values
- Tax depreciation and tax expense
- Project financing
- Load schedule
- Water demand and supply
- Water revenues
- Operating expenditure
- Working capital
- Financial Analysis Module: in this module, you are required to do the following:
- Construct an Income Statement for this project.
- Construct a Financial Cash Flow from the Total Investment Point of View.
- Compute the project’s Annual Debt Service Coverage Ratios (ADSCRs) and Loan Life Coverage Ratios (LLCRs).
- Construct a Financial Cash Flow from the Equity Point of View.
- Compute the project’s financial viability indicators (the project’s Net Present Value [NPV] and the Internal Rate of Return [IRR]).
- Sensitivity Analysis Module: In this module, you are required to undertake sensitivity analysis on the following project input variables:
- Domestic Inflation Rate (2% – 14%)
- Foreign Inflation Rate (1% – 5%)
- Percentage Change in the Initial Proposed Water Tariff (-20% – +20%)
- Investment Cost Overrun Factor (-30% – +30%)
- Real Interest Rate (1.5% – 3.5%)
Assignment 2:
Having completed the spreadsheet model of the Hayatsu Water Supply project, you should use the results from your model to make a holistic assessment of the feasibility of undertaking this project. Based on your appraisal, prepare a 1–2 page report, summarizing your main findings and conclusions. Your report should focus on the financial and risk impacts of the project. You may use the questions below as a guide to what are the key aspects to focus on in your report.
Financial Impacts:
- Given the project’s returns (NPV and IRR) should the equity holders go ahead with this project?
- Given the project’ ADSCRs and LLCRs, does the project generate enough cash flow to service its debt obligations? Should the ADB finance this project?
Risk Impacts:
- What are the key risk variables, and how do they affect the financial viability and sustainability of the project? (i.e., how do the risk variables affect the project’s returns and its ability to service the loan facility?).
- What are the implications of the assumed percentage change in the initial proposed water tariff, change in investment costs and change in the real interest rate to the overall attractiveness of this project, both from the owners and lenders point of view?
- What measures can be taken to mitigate or manage the project’s risks?