The Incremental Investment Problem Ever noticed that whenever some project or purchase looks likes its going to be a go, people come out of the wood work to add on –The salesman - for just a little bit more we can add on this feature. –Your partner - you say ok to $750 in furniture and they want the $825 set that is a little nicer –You engineer a good project and people start tacking extras all over it

Are the Add-Ons Worth While? Can always redo the cash flow with the change and then analyze –trouble is you confound the add on with the original how do you know if bad ideas are being subsidized from the success of good ideas? Can suggest doing before and after NPVs but NPVs can get bigger because the projects is bigger –Add on often cause unconventional cash flows

Standard Solution Write down the cash flow of the project before the add on Write down the cash flow after the add on Take cash flow with the add on minus the cash flow before the add on –Remember from the all cost alternatives problem that this gives you a cash flow that represents the advantage of choosing one instead of the other –In this case the advantage of adding onto the project.

Finishing the Problem Now do the cash flow on the new cash flow This will show you the value and costs brought to the total process by adding it on

Electric Utility Loads Over the course of a day the electric load on the power grid varies

Loads vary with Season

Utility Implications Baseload plants will run constantly. Their capital cost will be spread over many kilowatt hours of power, but operating cost, especially fuel will be critical –Tends to favor coal plants Peaking Plants are just the opposite. Need to be cheap, quick to fire up. Operating costs are less important because peak power sells for a big premium. –Tends to favor gas turbines

Example Problems Mount Butterscotch Electric Owns an electric distribution system, but no power plants. With increasing power prices Mount Butterscotch believes that they can enter the generation business and make money for themselves instead of passing money on to others. Vanna Vanilla has proposed to the boss that they enter the market with a 400 megawatt power plant. The proposed plant would be powered by coal and would only be down for maintenance and running all the time except for that. Power would sell for 4.5 cents/KWH onto the bus bar. The plant would run 90% of the time. The fuel and maintenance for the plant would run 1.7 cents/KWH. The plant would cost $120,000,000 to build plus an annual payment for debt financing of $29,000,000 for 30 years (the estimated life of the power plant). The money would be spent over a period of 3 years with earnings and debt payments starting in the 3rd year. The company investors demand a 12% rate of return. Is Vanna’s boss likely to approve the project?

Drawing Pictures 3 $53,600,000 Operating Cost $29,000,000 Debt Cost $141,900,000 Electric Sales Revenue $40,000,000 each year ……………… $59,300,000 Net Earnings each year What Kind of Problem is This?

Place the Pot and Identify Components $40,000,000 each year ……………… $59,300,000 Money Pot What is this? P/A 12,2 * $40,000,000 What is this? P/A 12,30 * $59,300,000 What are we going to do about the money getting dropped short of the pot? * P/F 12, 2

The Result The NPV on Vanna Vanilla’s project was positive. - Exercise for you - Calculate exactly what the NPV was on Vanna’s project. Tommy Topping decides that Vanna was too timid in her venture into the generation business and proposes that the power plant should be 500 Megawatts instead. Tommy Topping’s revenue projection is given below. $48,500,000 each year ……………… $72,700,00

What to do Next We could do an NPV on Tommy’s investment but the problem is that extra earnings from Vanna’s project could cover up for Tommy’s next increment being a bad idea. We apply incremental investment and subtract Vanna’s project from Tommy’s to see the merit of Tommy’s next project expansion over Vanna’s base case. $48,500,000 each year ……………… $72,700,00 Minus $40,000,000 each year ……………… $59,300,000

The Incremental Cash Flow $8,500,000 each year ……………… $13,400,000 Do an NPV on this cash flow and find out whether Tommy really did top Vanna’s idea.

More Ideas Ivan Moore has examined ideas by Vanna and Tommy. Ivan believes that the company should build a plant with two separate 300 megawatt units for a total of 600 megawatts. Ivan points out that designs by both Vanna and Tommy miss baseload generating opportunities because the equipment has to be turned off for maintenance. By building extra capacity that won’t run all the time they will pick up more baseload generation and pick up part of the cycling load. Ivan projects the cash flow below. 58,800,000 each year ……………… $81,400,000

Moore Assignment Use the Incremental Investment technique to find out whether Ivan Moore’s next increment (from a 500 megawatt plant to a 600 megawatt plant) is justified.

Additional Office Stooges Riley Big believes in big coal plants. He proposes that the company should build an 800 Megawatt plant using two 400 Megawatt generating units. Riley points out his plan does everything that everyone elses does and moore. Riley shows that his plant can generate the cash flow below. 74,700,000 each year ……………… $83,300,000

Making the Assignment a Riley Big Banana Split The first part of your assignment was to get the NPV on Vanna Vanilla’s cash flow The second part was to get the NPV of Tommy Topping’s next increment of power from 400 megawatts to 500 megawatts to see whether he really did get on top of Vanna’s project. The third part was to check Ivan Moore’s next increment of power going from 500 megawatts to 600 megawatts and splitting to two 300 megawatt units. Use the incremental investment technique to find the incremental cash flow and then check the NPV on the next increment.

Finishing the Banana Split (your assignment) Riley Big has proposed an even larger power plant at 800 megawatts. If Ivan Moore’s next increment is not economic, then Riley’s project need not be checked. If Ivan’s project made sense check Riley’s next increment above Ivan’s. Somewhere one of these next increments are not going to make sense because the capacity factor keeps falling for the next size up yet few economies of scale are being realized. Indicate what size power plant Mnt. Butterscotch should build (build to the last economically justified increment, but don’t build an increment that doesn’t make sense. For the last increment of power that did not make sense (its going to be Ivan’s or Riley’s) do an NPV on the total cash flow rather than the incremental cash flow. What answer would you got. Explain why incremental analysis leads you to make the correct decision about project size, while simply doing invest and earn problems for project sizing would not.

Incremental Analysis Problems can also take All Cost Alternatives Form Example - Power companies have to meet peak demands on the system. Some of these peaks seldom happen. In the past under regulation utilities were charged to give reliable service and allowed to pass the cost of that service onto their customers. Utilities built power plants to always stay ahead of demand. Under deregulation utilities are not guaranteed that they can pass costs onto customers so the utility industry stopped building. Over the past 4 years we have had major problems most of the summers with peak demands that are too high to meet (ok California has problems during the winter too). In these cases the price of peak power goes to crazy prices. A kilowatt hour of electricity that sells for about 9 cents may cost $7.00. All of California’s major utilities went bankrupt because they had to pay high prices that they could not pass on. A lot of power trading companies have also gone broke.

Incremental Analysis in All Cost Alternatives To guard against wild prices for peak power some utilities have built peaking power plants just so they won’t have to go buying power when the market is tight. Mnt. Butterscotch is considering building a cover your ____ (CYA) power plant to handle extreme peak conditions. If they do not build the plant, they will have to buy power at the market price (even though they can’t sell it for that). Mnt. Butterscotch analysis have concluded the following.

Cost for Peaking Power

Cost if Mnt Butterscotch builds CYA Power Plant …………………… $4,375,000 per year to build $3,380,000 per year to retire debt and run plant

Cost if Mnt Butterscotch does nothing and buys its peaking power …………………... $53,217,000 per year in emergency power purchases

I think building the CYA Power Plant Makes More Sense ………………… $4,375,000 per year to build $3,380,000 per year to retire debt and run plant Minus …………………... What Kind of Problem am I setting Up?

Resulting Cash Flow $4,375,000 …………... $49,837,000 each year Why do I not think this one will be hard to figure NPV = $256,682,266

Now the Incremental Analysis Version of All Cost Alternatives Candy Sprinkles suggests that the gas peaking plant should be built to 275 megawatts of capacity rather than just 175 megawatts. If the larger power plant is built, the cost of running it will be as below. …………………… $6,875,000 per year to build $5,940,000 per year to retire debt and run plant

If No Plant is built The result of building no plant at all is as below …………………... $62,090,000 each year

The value of building a 275 megawatt plant over nothing …………………… $6,875,000 per year to build $5,940,000 per year to retire debt and run plant Minus …………………... $62,090,000

Worth of Building the 275 Meg Peaking Plant $6,875,000 …………... $56,150,000 I bet your waiting for me to do an NPV

Now we compare the benefits of the 275 Meg Plant against the 175 Meg Plant $6,875,000 …….. $56,150,000 The 275 Meg Plant goes in first. Minus $4,375,000 …….. $49,837,000 The 175 Meg Plant goes in second.

New Arrive at the Benefits of Building the Next Increment of Capacity $2,500,000 …………... $6,313,000 NPV = $28,832,000

Do You Catch The Pattern In the All Cost Alternatives Form you have several cash flow subtraction steps –Take cost of the base case cash flow –Take cost of the do nothing alternative –Subtract the do nothing alternative from the base case - Get Benefits of Base case cash flow –Take the expanded case cash flow –Take cost of do nothing (bigger plant so bigger difference) –Subtract the bigger do nothing alternative from the bigger plant - Get Benefits of the Bigger Plant –Now subtract the Benefits of the Base Case from the benefits of the bigger plants - Get the benefits of building bigger.

Lets Try it Again Wally Nuts wants to put his idea on the peaking plant too. Wally says they should build a 375 Megawatt Peaking Plant, rather than a 275. Wally offers this cost to build his plant. …………………… $9,375,000 per year to build $8,810,000 per year to retire debt and run plant

If 375 Meg Plant is Not Built …………………... $67,200,000

375 Meg Plant minus No Action $9,375,000 …………... $58,390,000

Subtract Benefit of the 275 Meg Plant from the Benefit of the $2,500,000 …………... $2,240,000 NPV = 7,177,000

Checking the Next Increment Prunella Raisen suggests building a 475 megawatt peaking plant. Her cash flow is as below. …………………… $11,875,000 per year to build $12,590,000 per year to retire debt and run plant

The No Action Cash Flow …………………... $71,200,000

Your Assignment Determine whether the 375 megawatt peaking power plant should be sized up to a 475 megawatt peaking plant like Prunella says. (Be sure to clearly show your work and explain the steps you went through to reach your conclusion).