Question

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ABC Limited is a large agricultural producer that owns around one million hectares of land, most of which is used to run cattle bound for global markets. Recently, the Board and managers of ABC have been closely watching the rapid growth in popularity of meat alternatives, including imitation meat, and see it as a reflection of broader societal trends towards healthier lifestyles and reducing carbon footprint. The Board are concerned about the potential long-term negative impact of these trends on the company’s value and it has led them to reconsider the company’s strategy. Given the size of the company’s land holdings, several alternative land use options have been considered. A move to the production of non-meat agricultural products has been ruled out because most of the company’s land is not suitable for the viable production of such products. Mining ventures have also been ruled out because none of the land contains a profitable level of resources except coal, which the Board has decided is not appropriate to deal with their aim to become a more environmentally responsible business. Coal is a hotly debated topic in energy and climate policy. The most recent proposal being examined by ABC is renewable energy production. Renewables are considered crucial in the transition to a low-carbon, sustainable future according to The International Energy Agency: In 2018, renewable electricity generation rose 7%, with wind and solar PV technologies together accounting for 65% of this increase. Although the share of renewables in global electricity generation reached 25% in 2018, renewable power as a whole still needs to expand significantly to meet the SDS [Sustainable Development Scenario] share of almost half of generation by 2030. This Specifically, ABC are considering a wind farm . The company is now close to the final investment decision stage and the CEO has asked you to put together a financial analysis of the project. You will submit a summary of this analysis, along with your recommendations on the project, in a short memo The company owns several parcels of land that a wind study has indicated are suitable for power generation by wind turbines. One parcel in particular has been singled out as the best based on wind, geology, grid connection access, minimal environmental impact, local government consent and positive community attitudes in the area towards wind towers. Cattle currently run on this land but the company believes this activity would not be severely impacted by the wind farm. The stock would need to be removed during construction of the wind towers but existing stocking rates could be resumed once the wind towers are operational. Costs associated with this disruption in current activities during wind tower construction are estimated to be $0.2million net of tax effects. In addition to the wind study, the company has incurred other project development costs, including for a geological study and environmental impact assessment, engaging the services of several relevant professionals, holding community consultations and receiving local government development approval. These project development costs have totalled $0.8m. The wind farm will consist of ten, 2MW turbines, giving the wind farm a total rated capacity3 of 20MW. Each turbine will cost $2.2 million and related installation costs (including construction and grid connection, which are all depreciable) will be an additional $0.5 million for each turbine tower. The plant and equipment will be depreciated to a zero book value on using the prime cost method over 20 years. A proportion of the financing for the plant and equipment will be via a new 20-year debt issue, resulting in interest costs of $2 million payable at the end of each year. At the end of 20 years, the wind farm will be decommissioned and the plant and equipment sold for an estimated market value of $4 million. Estimated decommissioning costs are $3 million. The rated capacity of the wind farm per hour (20MW) will not be available at all times due to winds that are lighter or stronger than the optimal wind speed range. Engineers from the turbine supplier have therefore suggested assuming a capacity factor4 of 40%, which means that the farm would be expected to produce 70,080 MW hours (MWh)5 of electricity each year, assuming continual operation. However, this is an uncertain estimate due to the variability of wind and the potential for repair and maintenance outages. Global capacity factors for onshore wind have been increasing over time, as seen in the graph on the next page, but the 2018 global average capacity factor was lower than the estimate provided by the turbine supplier’s engineers and there has been a wide range of achieved capacity factors each year. ABC has negotiated a 10-year Power Purchase Agreement (PPA) that gives a guaranteed $40 per MWh. After this agreement expires, ABC assumes it will sell the electricity in the open market, starting with an estimated average price of $70 per MWh in the first year and increasing 3% per year after that. However, electricity prices are extremely volatile with a standard deviation of 40% of average price. 3 Rated capacity is the peak hourly production of a wind turbine when conversion efficiency is near its maximum. This requires optimal wind speed, amongst other conditions. 4 Capacity factor is average power generated divided by rated capacity. For example, if a wind turbine with a 2MW rated capacity produces power at an average of 1MW, its capacity factor is 50% (1÷2). 5 Calculated as rated capacity x 365 days x 24 hours x capacity factor = 2MW x 365 days x 24 hours x 40%. This assumes the wind turbines are always operational. In addition to revenue from selling electricity, ABC will qualify for a government scheme providing green certificates at a rate of one certificate per MWh of renewable energy produced. These certificates have value in the market for retailers who need to meet certain renewable targets. ABC will sell their certificates at the end of each year for an estimated $20 each. Based on expert opinion, ABC predicts that the government will end the scheme after 10 years when it is forecast to meet its renewable energy targets. The contract with the turbine supplier specifies that most service and maintenance of the turbines will be the supplier’s responsibility for 20 years. Therefore, operational costs are expected to be low. Variable operating costs are forecast to be $2 per MWh in the first year and increase at a rate of 2% throughout the life of the project. An additional $1 million annually in administration, insurance and general expenses (excluding depreciation) directly related to the project will also be incurred. ABC has a 8% weighted average cost of capital and is subject to a 30% tax rate on its income. After some research and calculations, you have determined that ABC has a higher unlevered beta, adjusted for cash, then a pure play wind electricity generating company, listed on the same stock market as ABC. Unlevered beta adjusted for cash is a measure of business risk. Required: Prepare (1) a spreadsheet financial analysis of the proposed project and (2) a memo to ABC’s CEO that briefly explains and justifies your chosen methods, inputs and any assumptions made, summarises your findings, and presents your recommendations on the proposed options. Ensure you not only analyse base case (expected) cash flows but also analyse and discuss potential uncertainty. Recommendations should address the decision to be made, along with any further follow up or other matters the company should consider prior to making a final decision.

Answer 1

Memo to ABC CEO: The project should not be taken up as it will not generate enough funds.
Sales		2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	4,905,600	5,052,768	5,204,351	5,360,482	5,521,296	5,686,935	5,857,543	6,033,269	6,214,267	6,400,695
sale of scrap																						4,000,000
TOTAL	0	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	2,803,200	4,905,600	5,052,768	5,204,351	5,360,482	5,521,296	5,686,935	5,857,543	6,033,269	6,214,267	6,400,695	4,000,000
Disruption cost	200,000
Project dev. Cost	800,000
Turbin cost	22,000,000
Installation	5,000,000
Interest		2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000	2,000,000
Decommissioning cost																						3,000,000
Operating cost		140,160	142,963	145,822	148,739	151,714	154,748	157,843	161,000	164,220	167,504	170,854	174,271	177,757	181,312	184,938	188,637	192,410	196,258	200,183	204,187
Administration cost		1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000
Depreciation		1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000	1,400,000
TOTAL	28,000,000	4,540,160	4,542,963	4,545,822	4,548,739	4,551,714	4,554,748	4,557,843	4,561,000	4,564,220	4,567,504	4,570,854	4,574,271	4,577,757	4,581,312	4,584,938	4,588,637	4,592,410	4,596,258	4,600,183	4,604,187	3,000,000
Balance	-28,000,000	-1,736,960	-1,739,763	-1,742,622	-1,745,539	-1,748,514	-1,751,548	-1,754,643	-1,757,800	-1,761,020	-1,764,304	334,746	478,497	626,594	779,170	936,358	1,098,298	1,265,133	1,437,011	1,614,084	1,796,509	1,000,000
Cumulative	-28,000,000	-29,736,960	-31,476,723	-33,219,346	-34,964,885	-36,713,398	-38,464,946	-40,219,589	-41,977,389	-43,738,409	-45,502,713	-45,167,967	-44,689,470	-44,062,876	-43,283,707	-42,347,349	-41,249,051	-39,983,917	-38,546,906	-36,932,822	-35,136,313	-34,136,313