PowerCo is the largest power generating company selling electricity throughout many states in the southeast region of the United States. The company also believes that the demand of the electricity would increase over the next 10-12 years. The current capabilities of the company are not enough to meet this estimated demand over the next decade. The management of PowerCo has decided that they need to build a new generator in order to meet the anticipated high demand appropriately.
It is an estimate that the building of the new generator would be completed within two years and this generator would remain functional for the next ten years. A financial analysis has been done according to the projections with the help of the Treasury Department, which is given below.
Q1. PV of the Expected Cost at 8%
Year 1: PV= $25 * 0.926= $23.15
Year 2: PV= $28 * 0.857= $23.996
Total Cost= $23.15+ $23.996= $47.15million
Q2. PV of after tax cash inflows with 8% interest rate
Year 3: PV= $6 * 0.794= $4.764
Year 4: PV= $7 * 0.735= $5.145
Year 5: PV= $8 * 0.681= $5.448
Year 6: PV= $9 * 0.63= $5.67
Year 7: PV= $9 * 0.583= $5.247
Year 8: PV= $9 * 0.54= $4.86
Year 9: PV= $9 * 0.5= $4.5
Year 10: PV= $9 * 0.463= $4.167
Year 11: PV= $9 * 0.429= $3.861
Year 12: PV= $9 * 0.397= $3.573
Total PV of cash inflows= $47.24million
Q3. Net Present Value is the difference between the PVs of outflows and inflows.
NPV= $47.24 - $47.15= $0.09million; this is a positive net present value which states that the expected profits are greater than the expected costs. The cash outflows in the first two years are the project costs when being built and the cash inflows would be the profits generated from the project. This positive NPV shows that the investment would generate a profit in returns therefore, it can be and it should be made. If the case was a negative net present value, then the investment should have been avoided as it exhibits a potential loss.
Q4. First and the main risk associated with the building of the facility is that there is no absolute calculation of the cash flows and costs; all the mentioned figures are expected. The anticipated cash flows is based on the sales and demand that is stretched over a period of ten years which can never be truly estimated at the moment. By the end of the first two years, the company is opting for an optimistic outlook on the demand. The duration of the ten years seems to be on a very conservative side according to the department of treasury but, one thing not considered is the risk of changing rate of inflation which has the potential to vastly change the outcome of the expected cash flows after tax.
Q5. Reviewing all the data calculated above, my recommendation is that the company should definitely carry on with the investment in this project. As the net present value is positive, the company is expecting a profit of $0.09million as calculated above. There is also a chance that the cash flows may continue longer than simply ten years. Although the company has taken a conservative side but there are many chance that the cash inflows may come for more than ten years which means that the NPV would be even greater. Let’s assume even the cash inflow remains the same at $9 million but it come for 13 years the PV would be:
Year 13: PV= $9 * 0.386= $3.312
Year 14: PV= $9 * 0.34= $3.06
Year 15: PV= $9 * 0.315= $2.84
If we calculate now, the NPV= $56.44 - $47.15= $9.29million; this shows that if the life of the project simply increases by 3 years, the NPV increases to $9.29 million. So, this investment should be made as it is in the best interest of the company.