1. Incremental All Cost Alternatives ©Dr. Bradley C. Paul 2002 Note – The concepts shown in these slides are considered to be commonly known amongst those schooled in the practice of Engineering Economics and these and similar ideas are published in a variety of forums no one of which was intentionally used by the author in the preparation of these slides.

2. 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.

3. 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.

4. Cost for Peaking Power Last 175 Megawatts of Capacity is going to be Real Pricey to Buy

5. Cost if Mnt Butterscotch builds 175 Meg CYA Power Plant …………………….. 0 1 2 3 4 5 19 20 21 $4,375,000 per year to build $3,380,000 per year to retire debt and run plant

6. Cost if Mnt Butterscotch does nothing and buys its peaking power 0 1 2 3 4 5 18 19 20 21 …………………... $53,217,000 per year in emergency power purchases

7. I think building the CYA Power Plant Makes More Sense …………………. 0 1 2 3 4 5 19 20 21 $4,375,000 per year to build $3,380,000 per year to retire debt and run plant Minus 0 1 2 3 4 5 18 19 20 21 …………………... What Kind of Problem am I setting Up? Cost of Building 175 Meg Plant Cost of Buying last 175 Meg of Power Needed

8. Resulting Cash Flow 0 1 2 3 5 6 7 18 19 20 21 $4,375,000 …………... $49,837,000 each year Why do I not think this one will be hard to figure NPV = $363,973,412 at 12% real rate Cost and Savings from Having 175 Meg Plant Instead of Buying peak Power from Others

9. 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. …………………….. 0 1 2 3 4 5 19 20 21 $6,875,000 per year to build $5,940,000 per year to retire debt and run plant Cost of Building and Operating a 275 Meg Peaking Power Plant

10. If No Plant is built The result of building no plant at all is as below. 0 1 2 3 4 5 18 19 20 21 …………………... $62,090,000 each year

11. The value of building a 275 megawatt plant over nothing Minus …………………….. 0 1 2 3 4 5 19 20 21 $6,875,000 per year to build $5,940,000 per year to retire debt and run plant Cost of 275 Meg Plant 0 1 2 3 4 5 18 19 20 21 …………………... $62,090,000 Cost of Buying last 275 Meg Of Power

12. Worth of Building the 275 Meg Peaking Plant 0 1 2 3 5 6 7 18 19 20 21 $6,875,000 …………... $56,150,000 I bet your waiting for me to do an NPV

13. 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.

14. New Arrive at the Benefits of Building the Next Increment of Capacity 0 1 2 3 5 6 7 18 19 20 21 $2,500,000 …………... $6,313,000 NPV = $42,422,455 at 12% Cost and Benefit of Adding 100 Meg Of Peaking Capacity To 175 Meg Peaking Plant

15. 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.

16. 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. …………………….. 0 1 2 3 4 5 19 20 21 $9,375,000 per year to build $8,810,000 per year to retire debt and run plant

17. If 375 Meg Plant is Not Built (ie no plant at all) 0 1 2 3 4 5 18 19 20 21 …………………... $67,200,000

18. 375 Meg Plant minus No Action 0 1 2 3 5 6 7 18 19 20 21 $9,375,000 …………... $58,390,000

19. Subtract Benefit of the 275 Meg Plant from the Benefit of the 375 0 1 2 3 5 6 7 18 19 20 21 $2,500,000 …………... $2,240,000 NPV = 11,999,411 at 12% Cost and Benefit Of adding 100 Megawatts to A 275 Meg Peaking Power Plant

20. Checking the Next Increment Prunella Raisen suggests building a 475 megawatt peaking plant. Her cash flow is as below. …………………….. 0 1 2 3 4 5 19 20 21 $11,875,000 per year to build $12,590,000 per year to retire debt and run plant

21. The No Action Cash Flow 0 1 2 3 4 5 18 19 20 21 …………………... $71,200,000

22. 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).