Example Finance Essay: Capital Appraisal of Power Generating Alternatives

Example Finance Essay: Capital Appraisal of Power Generating Alternatives
Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case.
The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one.

Capital Appraisal

The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio.

According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199).

Expected return on equity = Risk-free return + Beta*(Market return – risk-free return)

The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return.

The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey & Myers, 2003, p. 389).

WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E)
Where
Rd = Return on debt
T = Taxation rate
Re = Return on equity
D = Value of debt
E = Value of equity

D/(D+E) is the gearing ratio of a company.

The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided.

Table I – Cost of equity and WACC

The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates.

The net present value calculations for the three options are based on the following common assumptions:

The power plant starts operations at the beginning of the 4th year.
The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate.
All yearly cleanup costs are also increased by the annual inflation rates to take into account the likely increase in costs over years.
The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period.
It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself.
The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options.
The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations.

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