Question

An electric utility company is considering a new power plant in northern New Mexico. Electricity generated at the plant would be sold in the Albuquerque market where it is badly needed. The firm has the possibility of building a plant that will meet their production needs for the next several years that will cost $300 M. They also have the option of building a larger facility that will have a higher production capacity and will allow them to sell some excess power to another utility company under a long-term contract. The larger facility will cost $600M. The anticipated cash flows for each plant are as follows:

Year	Small Facility Cash Flow in Millions	Large Facility Cash Flow in Millions
1	$150	$200
2	$175	$225
3	$200	$250
4	$225	$275
5	$250	$300
6	$275	$325
7	$300	$350
8	$300	$375
9	$300	$400
10	$300	$450

At the end of ten years, both facilities will need significant upgrades and the company plans to conduct further analysis at that time. The risk adjusted cost of capital for this project is 12 percent.

1. Choose a course of action for the company and justify your decision for the managers of the company.

Answer 1

Select the Project with higher NPV.

NPV = PV of Cah inflows - PV of Cash Outflows

Small Project:

Year	CF	PVF @12%	Disc CF
0	$ -300.00	1.0000	$   -300.00
1	$ 150.00	0.8929	$    133.93
2	$ 175.00	0.7972	$    139.51
3	$ 200.00	0.7118	$    142.36
4	$ 225.00	0.6355	$    142.99
5	$ 250.00	0.5674	$    141.86
6	$ 275.00	0.5066	$    139.32
7	$ 300.00	0.4523	$    135.70
8	$ 300.00	0.4039	$    121.16
9	$ 300.00	0.3606	$    108.18
10	$ 300.00	0.3220	$      96.59
NPV			$ 1,001.61

Large Project:

Year	CF	PVF @12%	Disc CF
0	$ -600.00	1.0000	$   -600.00
1	$ 200.00	0.8929	$    178.57
2	$ 225.00	0.7972	$    179.37
3	$ 250.00	0.7118	$    177.95
4	$ 275.00	0.6355	$    174.77
5	$ 300.00	0.5674	$    170.23
6	$ 325.00	0.5066	$    164.66
7	$ 350.00	0.4523	$    158.32
8	$ 375.00	0.4039	$    151.46
9	$ 400.00	0.3606	$    144.24
10	$ 450.00	0.3220	$    144.89
NPV			$ 1,044.45

Large Project is selected as it has Higher NPV.