Case 097Capital allocation and corporate actionsCore

A steel company plans to double capacity for Rs 8,000 crore against a market value of Rs 12,000 crore. The new plant's mid-cycle ROCE is 11% against a 12% cost of capital. Should the market welcome it?

The situation

Dhruvaka Metals makes long steel products and is valued at Rs 12,000 crore. Management announces a plan to double capacity with a new integrated plant costing Rs 8,000 crore, spent evenly over three years of construction. Steel is cyclical, and your estimate of the plant's return on capital employed through a full cycle, after tax, is 11%. Dhruvaka's cost of capital is 12%.

Management's presentation stresses that the plant doubles volume, lifts EBITDA by 80% at mid-cycle prices, and makes Dhruvaka the second-largest producer in its region.

Your task

Does the expansion create or destroy value, how much, and what would have to be true for the market to welcome it?

Quick check

The new plant earns 11% on capital that costs 12%. Is that a small problem or a large one?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

No: at 11% against a 12% cost of capital, the plant destroys about Rs 1,185 crore of value, roughly 10% of the company. The plant would be worth Rs 7,333 crore once built, less than the Rs 8,000 crore it costs, and three years of construction with no return deepen the gap. Growth that earns below its cost of capital destroys value, however much EBITDA it adds. The plant needs a mid-cycle ROCE of about 13.5% to break even.

Step 1Why does an 11% return on a 12% cost destroy value?

Because the money has to come from someone who could earn 12% elsewhere. A family that borrows at 12% to buy a flat that rents for 11% of its price gets a bigger asset and a smaller net worth every year. Growth that earns below its cost of capital destroys value: the plant earns Rs 880 crore a year on capital that costs Rs 960 crore. Capitalised at 12%, Rs 880 crore a year is worth Rs 7,333 crore, Rs 667 crore less than the Rs 8,000 crore put in, even if the plant appeared overnight.

Step 2What do the three construction years add?

A second, larger loss. Rs 2,667 crore goes in each year for three years, worth Rs 6,405 crore in today's money, while the plant earns nothing. The finished plant, worth Rs 7,333 crore three years out, is worth only Rs 5,220 crore today, so the project destroys about Rs 1,185 crore. That is roughly 10% of Dhruvaka's value, which is what the market is likely to take off the shares when it does this arithmetic.

Rs 8,000 crore goes in; less comes out, in today's money8,000Invested7,333Worth-667If built overnight6,405Invested5,220Worth-1,185Built over three yearsRs crore, in today's money at a 12% cost of capital
Built overnight, Dhruvaka's Rs 8,000 crore plant would be worth Rs 7,333 crore, a loss of Rs 667 crore; built over three years it costs Rs 6,405 crore in today's money and is worth Rs 5,220 crore, a loss of Rs 1,185 crore.
Step 3What return would make the market welcome it?

Solve for the return where value created is zero. With a three-year build, the plant needs a mid-cycle ROCE of about 13.5%, not 12%, because capital sits idle while it is built. Every point of ROCE above that adds about Rs 475 crore of value. So the questions for management are specific: what cost position will the new plant have against the regional cost curveEvery producer ranked from lowest to highest cost per tonne; where a plant sits on it decides its margin through the cycle., whether captive iron ore or power lowers its cost, and whether the capex figure includes the cost overruns steel plants often suffer.

The plant must beat 13.5%, not 12%, once the build years count-4,000-2,000+2,00008%10%12%14%16%Mid-cycle return on capital of the new plantValue created, Rs crorecost of capital 12%break-even 13.5%11%: -1,185
Allowing for three years of construction, Dhruvaka's new plant destroys Rs 1,185 crore at an 11% mid-cycle ROCE and only breaks even at 13.5%, well above the 12% cost of capital.

Then give the view and its limit. On these numbers the market should not welcome the plan: EBITDA up 80% is a statement about size, not value. The view changes if the 11% is too conservative, for instance if steel demand in the region is structurally stronger than the last cycle, or if the plant is phased so that the first half earns before the second is committed. Phasing is the practical ask to put to management.

Where candidates lose it

The common mistake is to be swayed by the headline: EBITDA up 80%, volume doubled, market share gained. None of these says whether the money earns its cost, and the interviewer is testing whether you ask that first.

The second miss is treating 11% against 12% as a rounding difference. On Rs 8,000 crore it is Rs 80 crore a year, and the construction years turn it into a loss of about a tenth of the company.

What the interviewer asks next

  • Dhruvaka funds the plant with debt at 9%. Does that change the answer?
  • How would you estimate mid-cycle ROCE for a new steel plant?
  • The plan is phased: half now, half in three years if returns hold. How does that change the value?

Company names and figures are illustrative.