THE ISLAND DEVELOPMENT CORPORATION: CAPITAL BUDGETING
PROJECT CASE STUDY SOLUTION
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SYNOPSIS
In September 2022, Albert Rodriguez, chief executive officer (CEO) and founder of Maximum Quality
Equipment (Maximum), was trying to decide whether to invest in a joint venture company to operate a
quarry that would extract and sell rock armour. The joint venture company, Island Development
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Corporation (IDC), had secured a 25-year mineral production sharing agreement (MPSA) with the
Philippine government. IDC would purchase equipment and extract rock armour in Chiquita Island and
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then sell the rock armour to San Miguel Corporation (SMC), a major Philippine corporation. The contract
was currently under negotiation, with SMC offering a two-year contract and IDC asking for a five-year
contract. Rodriguez asked his chief financial officer, Maynard Lascano, to run a discounted cash flow,
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estimate the cost of capital for the project, and determine the net present value (NPV), internal rate of return
(IRR), and project payback. Rodriguez needed to decide whether he would invest in the project.
So
OBJECTIVES
• Describe the benefits and risks of a capital budgeting project.
• Determine and estimate relevant cash flows, including operating cash flows, capital expenditures,
working capital requirements, and sunk costs.
• Assess the importance of client contracts in determining a project’s viability.
• Explain and estimate the various components of the capital asset pricing model (CAPM)–based
weighted average cost of capital (WACC)—namely, cost of debt, cost of equity, weigh of debt, and
weight of equity—for a Philippine corporation.
The Case Solution Starts From page 5
,ASSIGNMENT QUESTIONS
1. Discuss the IDC’s capital budgeting project and its benefits and risks.
2. Estimate the cost of capital for the project, using the CAPM.
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3. Estimate free cash flows, NPV, IRR, and payback for the project over two years, in line with a two-
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year client contract.
4. Estimate free cash flows, NPV, IRR, and project payback over five years, in line with a five-year
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client contract.
5. Estimate free cash flows, NPV, IRR, and project payback over 10 years, in line with a 10-year client
contract.
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6. What would you recommend to Rodriguez about this project? How should project risks be addressed?
ANALYSIS
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1. Discuss the IDC’s capital budgeting project and its benefits and risks.
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Maximum was a leading construction and mining equipment distributor. CEO Rodriguez was invited by
the company’s long-time customer, Caesar Santiago of Caesar Construction Company (CCC), to consider
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investing in IDC, which would conduct quarrying activities in Chiquita Island to produce high-quality rock
armour that was well-suited for reclamation projects. Investing in IDC presented a good opportunity for
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Maximum to engage in downstream activities and offered a promising avenue for product expansion.
IDC had a 25-year MPSA with the Philippine government, which required IDC to pay 4 per cent of revenues
The Case Solution Starts From page 5
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6. What would you recommend to Rodriguez about this project? How should project risks be
addressed?
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The MPSA is a very important asset for IDC, and if it can derive full use of this, then the project will be
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lucrative. The main risk of the project was the length of the client contract because industry practice was to
grant relatively short contracts. If extraction of rock amour happens for only two years, the NPV would be
negative, and the IRR would be below the weighted average cost of capital. This is because the free cash
flows would be insufficient to cover the initial cost of setting up the operation. In particular, heavy
n
equipment has a high initial cost and does not have a strong market value once used, even if it still has more
years of remaining life. Extracting rock armour and selling this for five years shows robust NPV and IRR.
tio
These activities are better done with a long client contract; however, IDC may attempt to run a series of
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So
The Case Solution Starts From page 5
, EXHIBIT -4: TWO-YEAR FREE-CASH-FLOW AND NET-PRESENT-VALUE ESTIMATES (IN ₱)
Year 0 Year 1 Year 2
Revenues 1,650,000,000 1,739,100,000
Direct costs
Fuel expense -429,007,193 -452,173,581
Subcon hauling -750,000,000 -790,500,000
Subcon loading -90,000,000 -94,860,000
Total direct costs -1,269,007,193 -1,337,533,581
Gross profit 380,992,807 401,566,419
Operating expenses
Salaries and wages expense -30,000,000 -31,620,000
Excise tax
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Sa
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So
The Case Solution Starts From page 5
PROJECT CASE STUDY SOLUTION
e
pl
m
Sa
SYNOPSIS
In September 2022, Albert Rodriguez, chief executive officer (CEO) and founder of Maximum Quality
Equipment (Maximum), was trying to decide whether to invest in a joint venture company to operate a
quarry that would extract and sell rock armour. The joint venture company, Island Development
n
Corporation (IDC), had secured a 25-year mineral production sharing agreement (MPSA) with the
Philippine government. IDC would purchase equipment and extract rock armour in Chiquita Island and
tio
then sell the rock armour to San Miguel Corporation (SMC), a major Philippine corporation. The contract
was currently under negotiation, with SMC offering a two-year contract and IDC asking for a five-year
contract. Rodriguez asked his chief financial officer, Maynard Lascano, to run a discounted cash flow,
lu
estimate the cost of capital for the project, and determine the net present value (NPV), internal rate of return
(IRR), and project payback. Rodriguez needed to decide whether he would invest in the project.
So
OBJECTIVES
• Describe the benefits and risks of a capital budgeting project.
• Determine and estimate relevant cash flows, including operating cash flows, capital expenditures,
working capital requirements, and sunk costs.
• Assess the importance of client contracts in determining a project’s viability.
• Explain and estimate the various components of the capital asset pricing model (CAPM)–based
weighted average cost of capital (WACC)—namely, cost of debt, cost of equity, weigh of debt, and
weight of equity—for a Philippine corporation.
The Case Solution Starts From page 5
,ASSIGNMENT QUESTIONS
1. Discuss the IDC’s capital budgeting project and its benefits and risks.
2. Estimate the cost of capital for the project, using the CAPM.
e
3. Estimate free cash flows, NPV, IRR, and payback for the project over two years, in line with a two-
pl
year client contract.
4. Estimate free cash flows, NPV, IRR, and project payback over five years, in line with a five-year
m
client contract.
5. Estimate free cash flows, NPV, IRR, and project payback over 10 years, in line with a 10-year client
contract.
Sa
6. What would you recommend to Rodriguez about this project? How should project risks be addressed?
ANALYSIS
n
1. Discuss the IDC’s capital budgeting project and its benefits and risks.
tio
Maximum was a leading construction and mining equipment distributor. CEO Rodriguez was invited by
the company’s long-time customer, Caesar Santiago of Caesar Construction Company (CCC), to consider
lu
investing in IDC, which would conduct quarrying activities in Chiquita Island to produce high-quality rock
armour that was well-suited for reclamation projects. Investing in IDC presented a good opportunity for
So
Maximum to engage in downstream activities and offered a promising avenue for product expansion.
IDC had a 25-year MPSA with the Philippine government, which required IDC to pay 4 per cent of revenues
The Case Solution Starts From page 5
, e
pl
6. What would you recommend to Rodriguez about this project? How should project risks be
addressed?
m
The MPSA is a very important asset for IDC, and if it can derive full use of this, then the project will be
Sa
lucrative. The main risk of the project was the length of the client contract because industry practice was to
grant relatively short contracts. If extraction of rock amour happens for only two years, the NPV would be
negative, and the IRR would be below the weighted average cost of capital. This is because the free cash
flows would be insufficient to cover the initial cost of setting up the operation. In particular, heavy
n
equipment has a high initial cost and does not have a strong market value once used, even if it still has more
years of remaining life. Extracting rock armour and selling this for five years shows robust NPV and IRR.
tio
These activities are better done with a long client contract; however, IDC may attempt to run a series of
lu
So
The Case Solution Starts From page 5
, EXHIBIT -4: TWO-YEAR FREE-CASH-FLOW AND NET-PRESENT-VALUE ESTIMATES (IN ₱)
Year 0 Year 1 Year 2
Revenues 1,650,000,000 1,739,100,000
Direct costs
Fuel expense -429,007,193 -452,173,581
Subcon hauling -750,000,000 -790,500,000
Subcon loading -90,000,000 -94,860,000
Total direct costs -1,269,007,193 -1,337,533,581
Gross profit 380,992,807 401,566,419
Operating expenses
Salaries and wages expense -30,000,000 -31,620,000
Excise tax
e
pl
m
Sa
n
tio
lu
So
The Case Solution Starts From page 5
