Question

Kinder Morgan, an oil and gas pipeline company, is contemplating the expansion of its TransMountain Pipeline, which runs from Alberta to the British Columbia coast. The project is estimated to cost $7.4 billion and is expected to have a useful life of 15 years, with a salvage value of $0.5 billion. The new equipment will be added to an existing CCA Class with a rate of 5%. The pipeline expansion will increase capacity from the current level of 300,000 barrels per day to 890,000 barrels per day (assume 365 days/year). Kinder Morgan has signed contracts with Alberta’s major oil producers and will charge an average rate of $3.50 per barrel in the first year, and this rate will increase at a projected rate of 3% per year for future years. Variable costs are estimated to be 25% of the sales price. Fixed costs are $50 million per year and they are also expected to increase at a rate of 3% per year. It is also expected that the pipeline expansion will require an immediate investment in inventories of $15 million, accounts receivable of $10 million, and in accounts payable of $20 million. At the end of the expansion’s useful life, working capital will be reduced by $5 million. It is expected that Kinder Morgan will finance this project with 75% debt and the remainder with equity (e.g. new common shares). It is expecting to issue new debt with a maturity equal to the useful life of the project, with an annual coupon rate of 7% (coupons paid semi-annually), and it is projected to sell for 101% of par. Flotation costs on the new debt are expected to be 1.5%. It is expected that the new equity will have a systematic risk component based on its exposure to the S&P/TSX index beta of 0.85, and that the appropriate risk-free rate is expected to be 2%. The return on the S&P/TSX Index is 8.5%, Flotation costs on new equity are expected to be 2.5%. Kinder Morgan falls into the 34% corporate tax bracket.

1.What is the NPV of this project?

2. Prepare a short report on whether Kinder Morgan should proceed with the TransMountain expansion project. You may want to discuss what risk factors that may affect the viability of this project.

Answer 1

First we need to calculate WACC , to discount the project's cash flows:

After-tax Cost of debt:

Net proceeds of debt=PV of its future coupons +Pv of fac evalue to be recd. At maturity

Selling price-Flotation costs=$ Semi-annual coupon *(1-(1+r)^-n)/r)+(1000/(1+r)^n)

where,

Selling price =1000*1.01=1010

Flotation cost= 1010*(1-1.5%)=994.85 /bond

$ Semi-annual coupon= 1000*7%/2= $ 35

r= the semi-annual yield /cost of debt--- to be found--??

n= no.of semi-annual compoundind periods--ie. 15*2=30 (maturity equal to the useful life of the project)

Now, plugging these values, in the formula,

994.85=35*(1-(1+r)^-30)/r)+(1000/(1+r)^30)

we have the semi-annual before-tax cost as

3.5281%

so, the annual BT cost=

(1+3.5281%)^2-1=

7.1807%

Now the after tax annual cost =

BT cost*(1-Tax rate)

ie. 7.1807%*(1-34%)=

4.74%

Cost of new equity:

With the given inputs,as per CAPM,

Cost of equity, ke=RFR+(Beta*(Market return-RFR))

ie. 2%+(0.85*(8.5%-2%)=

7.53%

So, cost of new equity= Cost as per CAPM+flotation cost

ie.7.53%+2.5%=

10.03%

Now, the WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(25%*10.03%)+(75%*4.74%)

6.06%

Year	0	1	2	3	4	5	6	7
1.Initial cost	-7.4
2.Investment in working capital(-15-10+20)mln./1000 mln.	-0.005
3.ATCF on salvage
Operating cash flows:
4.Revenues(895000*365*3.50/1000000000) & *1.03 after yr.1		1.1433625	1.17766338	1.212993	1.249383	1.286865	1.325471	1.365235
5.Variable costs(Rev.in 4*25%)		-0.28584063	-0.2944158	-0.30325	-0.31235	-0.32172	-0.33137	-0.34131
6.Fixed costs(50000000/1000000000) &*1.03 after yr.1		-0.05	-0.0515	-0.05305	-0.05464	-0.05628	-0.05796	-0.0597
7.Depn. At( 5%*7.4 )		-0.37	-0.3515	-0.33393	-0.31723	-0.30137	-0.2863	-0.27198
8.EBIT(sum4 to7)		0.437521875	0.48024753	0.522775	0.565172	0.607506	0.64984	0.692239
9. Tax at 34%(8*34%)		-0.14875744	-0.1632842	-0.17774	-0.19216	-0.20655	-0.22095	-0.23536
10.EAT (8+9)		0.288764438	0.31696337	0.345031	0.373014	0.400954	0.428895	0.456878
11. Add Back: depn.(same row 7)		0.37	0.3515	0.333925	0.317229	0.301367	0.286299	0.271984
12. Opg. Cash flow(10+11)		0.658764438	0.66846337	0.678956	0.690242	0.702321	0.715193	0.728862
13.Total annual FCFs(1+2+3+12)	-7.405	0.658764438	0.66846337	0.678956	0.690242	0.702321	0.715193	0.728862
14.PV F at 6.06% (1/(1.0606)^Yr. n	1	0.942862531	0.88898975	0.838195	0.790303	0.745147	0.702571	0.662428
15.PV at 6.06%   (13*14)	-7.405	0.621124305	0.59425709	0.569098	0.5455	0.523332	0.502474	0.482819
16. NPV at 6.06%(sum of row 15)	0.325493
	billions

8	9	10	11	12	13	14	15
							0.005
							1.495641
1.406192	1.448377	1.491829	1.536584	1.582681	1.630162	1.679066	1.729438
-0.35155	-0.36209	-0.37296	-0.38415	-0.39567	-0.40754	-0.41977	-0.43236
-0.06149	-0.06334	-0.06524	-0.0672	-0.06921	-0.07129	-0.07343	-0.07563
-0.25838	-0.24547	-0.23319	-0.22153	-0.21046	-0.19993	-0.18994	-0.18044
0.734765	0.777479	0.820441	0.863709	0.907343	0.9514	0.995937	1.04101
-0.24982	-0.26434	-0.27895	-0.29366	-0.3085	-0.32348	-0.33862	-0.35394
0.484945	0.513136	0.541491	0.570048	0.598846	0.627924	0.657318	0.687066
0.258385	0.245466	0.233192	0.221533	0.210456	0.199933	0.189937	0.18044
0.74333	0.758602	0.774683	0.791581	0.809302	0.827857	0.847255	0.867506
0.74333	0.758602	0.774683	0.791581	0.809302	0.827857	0.847255	2.368147
0.624578	0.588892	0.555244	0.523519	0.493606	0.465403	0.438811	0.413738
0.464268	0.446734	0.430138	0.414407	0.399477	0.385287	0.371784	0.979793

CCA depreciation 5% on carrying value
Year	Depn.(Prev. carrying Value*5%)	Carrying value(prev. CV-current yr.depn.)
0		7.4
1	-0.37	7.03
2	-0.3515	6.6785
3	-0.33393	6.344575
4	-0.31723	6.0273463
5	-0.30137	5.7259789
6	-0.28630	5.4396800
7	-0.27198	5.1676960
8	-0.25838	4.9093112
9	-0.24547	4.6638456
10	-0.23319	4.4306534
11	-0.22153	4.2091207
12	-0.21046	3.9986646
13	-0.19993	3.7987314
14	-0.18994	3.6087948
15	-0.18044	3.4283551
Acc. Depn.	-3.971645
Salvage at end yr. 15		0.5
Carrying value as above		3.428355
Loss on salvage		2.928355
Tax exp. Saved due to loss(loss*34%)		0.995641
ATCF on salvage(salvage+tax saved)		1.495641

2. Kinder Morgan should proceed with the TransMountain expansion project

as the project's NPV is POSITIVE & hence will add value to the company & its shareholders.

Risk factors are:

1. Accuracy in prediation of demand

2. Accuracy of all variable & fixed costs & their escalation % age.

3. Requirement of working capital predictions

4. Costs associated with new issues of debt & equity

As the entre analysis is based on the numbers projected, there always lies the risk of the level of accuracy in all these predictions