Capital Appraisal Example
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Introduction
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 clean-up 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.
The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is ?1,636 million. The positive net present value of the power plant indicates that the firm’s value will increase by this amount if the project is run successfully over 25 years as per the projections.
The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WACC is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is ?1,062 million. This is ?574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method.
The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is ?1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant.
The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34).
The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return.
The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period method is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n’, then the discounted payback period is given by the following formula. .
Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n)
Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey & Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders.
Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and final value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0.
The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang & Swales, 1999, p.133).
The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77% which indicates that the cost of capital can increase substantially before the net present value of the project will become 0.
The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0.
The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return.
The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants.
The external consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe.
The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project.
Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate.
Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high gearing (Brealey & Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates.
The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices.
Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method.
Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the government’s policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model.
Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option.
Conclusion
The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods.
Personal learning
The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study.
First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey & Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%.
Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment.
Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not of nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option.
Bibliography and references
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Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company.
Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice & Education, Vol. 9, Issue 2, pp. 132-137.
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Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162.
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Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.
