Kidman Resources: Refinery vs. Outsourcing for Tesla Contract Analysis

This report analyzes two business opportunities for Kidman Resources, stemming from a contract with Tesla to supply 5000 tonnes of Lithium Hydroxide over three years. The company must decide between building a refinery or outsourcing ore supply. The analysis, based on a feasibility study, evaluates the Net Present Value (NPV) of each option. The report considers costs of construction, machinery, revenue, labor, depreciation, working capital, and tax implications. It utilizes the Capital Asset Pricing Model (CAPM) to determine the cost of equity and calculates the Weighted Average Cost of Capital (WACC). The analysis reveals a negative NPV for building a refinery, making it infeasible, while outsourcing shows a positive NPV. The report also includes beta analysis and concludes that outsourcing is the more financially viable option, recommending its adoption to expand the business and fulfill the Tesla contract. The analysis also provides all the required financial data for each option.

REPORT ON BUILDING
A NEW REFINERY OR
OUTSOURCING THE
SAME(ANALYSIS)

Contents
Introduction 4
Analysis-1 for Building a new Refinery 4
Rate of Return on Equity 5
Cost of debt 6
Analysis-2- For outsourcing of procurement of ore 6
Beta Analysis 7
Recommendation 9

Business Finance
Executive Summary
The report seeks to identify two business opportunity for Kidman Resources. The said
opportunity comes from a contract with Tesla Inc. whereby Kidman Resource shall supply
5000 tonnes of Lithium Hydroxide for a period of three years. The company has two ways of
providing the said resource to Tesla either through setting up its own refinery or outsourcing
the supply of ore.

Introduction
Kidman Resources has undertaken feasibility study for analysing the two projects
encompassing setting up of own refinery or outsourcing the purchase of ore. For the said
analysis, the company has already expended $ 2 Million for the purpose of analysing the
prospect. The said cost has not been considered for analysis as it is a sunk cost. Further, the
analysis encompasses the following assumption:
(i) S&P Asx is a true proxy of market;
(ii) Cost of current liabilities does not form part of computation of Weighted Average cost
of capital
(iii) Current Liabilities interest form part of working capital;
(iv) Working Capital is realised at the end of project;
(v) Rate of inflation has been considered at 2.8% for both revenue and cost
Analysis-1 for Building a new Refinery
The first proposition involves setting up a new refinery with the following facts:
(a) Cost of constructing and setting up new refinery shall be $22 Million;
(b) Cost of construction shall be $ 6 Million;
(c) Cost of setting up Machinery shall be $ 16 Million;
(d) Revenue foregone on account of usage of fleet is $ 0.12 Million per year;
(e) Revenue earned is $ 15 Million in first year which increases by 2.8%;
(f) Incremental cost of engineer is $ 0.2 Million in first year which increases by 2.8%;
(g) Cost of Labour is $ 3 Million in first year which increases by 2.8%;
(h) Depreciation on Machinery shall be written off in the first year to the full extent for tax
purpose;
(i) Depreciation on construction and installation of machinery has been written off over a
period of three years under straight line Method,
(j) Working capital required for the project is $ 2 Million and interest on the same has
been levied based on current cost on current liabilities by doing simple average;
(k) Tax has been considered @ 28%;
(l) Salvage Value has been considered at 10 Million being the residual value.
On the basis of Net Present Value of the project has been computed. The computation has
been provided as under:
Computation of Net Present Value of Refinery
Sl. No Particular 0 1 2 3
1 Installation cost of New Refinery -22.00
2 Construction Cost -6.00
3 Machinery cost -16.00
5 Revenue Foregone -0.12 -0.12 -0.12
6 Revenue 15.00 15.42 15.85

Computation of Net Present Value of Refinery
Sl. No Particular 0 1 2 3
7 Incremental cost of engineer -0.20 -0.21 -0.21
8 Cost of Labour -3.00 -3.08 -3.17
9 Depreciation on Machine Cost -16.00
10 Depreciation on construction and installation of New Refinery -6.00 -6.00 -6.00
11 Net working capital Required -2.00 -0.10 -0.10 -0.10
12 Profit before Tax -46.00 -10.42 5.91 6.25
13 Tax -2.92 1.66 1.75
14 Net Profit -7.50 4.26 4.50
15 Salvage Value 10.00
16 Depreciation 22.00 6.00 6.00
17 Working Capital 2.00
18 Feasibility Study Tax Impact 0.56
19 Cash Flow -45.44 14.50 10.26 22.50
20 Cost of Capital 1.00 0.88 0.78 0.69
21 Present Value -45.44 12.79 7.99 15.46
22 Net Present Value -9.20
On the basis of above, it can be seem that the Net Present Value computed under option -1 is
negative, hence the said project is not feasible. Further, for computing the net present value of
the project weighted average cost of capital has been considered. The computation of the
same has been carried out on the basis of market value of liabilities and equity.
Rate of Return on Equity
The Return on Equity has been computed by using Capital Asset Pricing Model wherein the
return from S&P ASX 200 has been considered a proxy of market and the beta has been
computed by dividing covariance of the stock and the market with the variance of the market.
Further, the formula of Capital Asset Pricing Model has been used to determine the rate of
return. The formula has been presented as under:
R(P)= Rf+ Beta of stock (R(M)- R(F))
The computation has been presented as under:
Computation of Cost of Equity
Sl No Particulars Amount
1 Beta 1.8288
2 Risk Free Rate 2.28%
3 Market Premium 7.70%
4 Cost of Equity 16.36%

Cost of debt
The cost of debt has been computed by considering the payment made net of tax. In the
present case, since tax is 28% and the coupon rate is multiple rate. The cost net of tax has
been considered.
The computation of Weighted Average Cost of Capital has been computed on the basis of
market value. The computation has been presented as under:
Computation of Cost of Capital
Sl
No Particulars
Amount(
W) Rate
Ta
x
Rate Net of
Tax
Weighted Average
Cost
1
Ordinary Share
Capital 494.1
14.01
% 14.01% 13%
2
Preference Share
Capital 0.9 5% 5.00% 0%
3 Long Term Debt
-Debentures 16 8% 2% 5.76% 0%
-Term Loans 8 6.25% 2% 4.50% 0%
-Mortgage 17 7% 2% 5.04% 0%
536
WACC 13.3264%
Analysis-2- For outsourcing of procurement of ore
The second proposition involves outsourcing of ore with the following facts:
(a) Revenue earned is $ 15 Million in first year which increases by 2.8%;
(b) An upfront cost of $ 5.6 Million;
(c) Cost of procurement shall be $ 7.47 Million per year;
(d) Processing Cost of $ 4.4 Million shall be incurred on year on year basis without any
change;
(e) Tax has been considered @ 28%;
On the basis of Net Present Value of the project has been computed. The computation has
been provided as under:
Computation of Net Present Value of Outsourcing
Sl No Particular 0 1 2 3
1 Revenue 15 15.42 15.85
2 Upfront Cost -5.6
3 Cost -7.47 -7.47 -7.47
4 Processing cost -4.4 -4.4 -4.4
5 Profit Before Tax -5.60 3.13 3.55 3.99
6 Tax -1.57 0.88 0.99 1.12
7 Feasibility Study Tax Impact 0.56
8 Net Profit -3.47 2.26 2.56 2.87
9 Cash flow -3.47 2.26 2.56 2.87

Computation of Net Present Value of Outsourcing
Sl No Particular 0 1 2 3
10 Discounting factor 1.00 0.88 0.78 0.69
11 Present Value -3.47 1.99 1.99 1.97
12 Net Present Value 2.48
On the basis of above, it can be seem that the Net Present Value computed under option -2 is
positive, hence the said project is feasible. Thus, option two is better compared to option-1.
Beta Analysis
Beta is a measure of systematic risk and is measured in terms of the market. The same may
fluctuate based on following factors:
(a) Demand and supply factor for the stock;
(b) Change in industry;
(c) Change in overall market;
(d) Change in the benchmark index;
(e) Change in business of the company;
(f) Change in Risk return profile of the company;
These are some of the reasons why the beta of the stock change.
Further, the computation under the changed beta has been presented as under:
Computation of Cost of Capital
Sl
No Particulars
Amount(
W) Rate
Ta
x
Rate Net of
Tax
Weighted Average
Cost
1
Ordinary Share
Capital 494.1
16.36
% 16.36% 15%
2
Preference Share
Capital 0.9 5% 5.00% 0%
3 Long Term Debt
-Debentures 16 8% 2% 5.76% 0%
-Term Loans 8 6.25% 2% 4.50% 0%
-Mortgage 17 7% 2% 5.04% 0%
536
WACC 15.4898%
Computation of Cost of Equity

Sl No Particulars Amount
1 Beta 1.82876409
2 Risk Free Rate 2.28%
3 Market Premium 7.70%
4 Cost of Equity 16.36%
Computation of Net Present Value of Refinery
Sl No Particular 0 1 2 3
1 Installation cost of New Refinery -22
2 Construction Cost -6
3 Machinery cost -16
5 Revenue Foregone -0.12 -0.12 -0.12
6 Revenue 15 15.42 15.85
7 Incremental cost of engineer -0.2 -0.21 -0.21
8 Cost of Labour -3 -3.08 -3.17
9 Depreciation on Machine Cost -16
10 Depreciation on construction and installation of New Refinery -6 -6.00 -6.00
11 Net working capital Required -2 -0.10 -0.10 -0.10
12 Profit before Tax -46 -10.42 5.91 6.25
13 Tax -2.92 1.66 1.75
14 Net Profit -7.50 4.26 4.50
15 Salvage Value 10.00
16 Depreciation 22 6.00 6.00
17 Working Capital 2.00
18 Feasibility Study Tax Impact 0.56
19 Cash Flow -45.44 14.50 10.26 22.50
20 Cost of Capital 1 0.87 0.75 0.65
21 Present Value -45.44 12.55 7.69 14.61
22 Net Present Value -10.59
Computation of Net Present Value of Outsourcing
Sl No Particular 0 1 2 3
1 Revenue 15 15.42 15.85
2 Upfront Cost -5.60
3 Cost -7.47 -7.47 -7.47
4 Processing cost -4.40 -4.40 -4.40
5 Profit Before Tax -5.60 3.13 3.55 3.99
6 Tax -1.57 0.88 0.99 1.12
7 Feasibility Study Tax Impact 0.56
8 Net Profit -3.47 2.26 2.56 2.87

Computation of Net Present Value of Outsourcing
Sl No Particular 0 1 2 3
9 Cash flow -3.47 2.26 2.56 2.87
10 Discounting factor 1.00 0.87 0.75 0.65
11 Present Value -3.47 1.95 1.92 1.86
12 Net Present Value 2.26
Recommendation
On the basis of above analysis, it can be concluded that option-2 is feasible since the Net
Present Value is positive under the said option compared to a negative Net Present value
under option-1. Thus, company should accept the project which has a positive net present
value and expand the business.