Table of Contents
Methods Used For Evaluation of Financial Feasibility of Proposed Project
Other Non-Quantitative Considerations
To: Chief Executive Officer
Subject: Financial Analysis of the proposed Windfarm project and recommendations
The financial analysis of the proposed Windfarm project involving the generation of electricity by wind turbines has been performed by us and the results of our financial analysis would be provided in this document.
Three techniques were used by us for evaluation of the proposed Windfarm project- net present value method, internal rate of return method, and payback period method. The results of the application of these three methods have been summarized below:
Net Present Value method
As per this method, a project must be selected only if it can generate a positive NPV (CFI, n.d.a). The results of our NPV Calculation showed that the proposed Windfarm project would provide a negative Net Present Value of $13.64 million. The main reason behind the negative net present value is that the present value of net annual cash inflows from the project are really low that they cannot cover the cost of initial investments. It is important to note here that cash inflows in the first 10 years of the project, from the sale of electricity @ $ 40 per MWH as per the power purchase agreement are much lower than the annual costs associated with the project that includes variable operating expenses, administration expenses, and annual interest costs of $2 million. The annual cash inflows generated from the 11th year onwards (when the company would be selling electricity in the open market at higher prices) are much higher and can easily cover the total annual costs of the project. This implies that this project can be turned into a profitable project if the electricity prices as per PPA in the first 10 years are increased to reflect open market rates. However, in the current scenario, based on the results of the NPV method, it is not financially feasible to undertake this project.
1. We have not considered the project development costs of $ 0.8 million that have already been incurred by the company in our NPV calculations as these are sunk costs now and will not have an impact on the acceptance or rejection of the said project.
2. The discount rate that has been used for arriving at the NPV is 8 percent which is equal to the weighted average cost of capital to the company. It has been assumed that the required rate of return on this project will be equal to the cost of capital of the company; hence the same has been taken as the rate of discount.
Internal rate of return
According to this technique of evaluation of capital budgeting projects, a project should be accepted only if its internal rate of return is more than its required rate of return (IRR, n.d.b). As per the calculations performed by us, the internal rate of return of this project is 1 percent while the required rate of return of the project is 8 percent, i.e., the IRR is much lower than the required rate of return. Hence, as per the results of the IRR method, it is not financially feasible to undertake this project.
The payback period refers to the time that will be taken by the project to cover the cost of the initial investment made in the project. As per the calculations performed by us, the payback period of the proposed project would be 18.29 years. This project will have a total life of 20 years and it will take approximately 18.29 years to cover the cost of initial investment of $ 27.2 million that was made into the project.
There are a lot of uncertainties involved in the above project which must be considered before deciding to go ahead with this proposal.
Volatility in the prices of electricity
As per the information available to us, the prices of electricity prevailing in the market are highly volatile such that there is a possibility that prevailing market prices could vary significantly (as high as 40 percent) from the average price. In such circumstances, it is not possible to estimate the cash inflows from the project with reasonable certainty. This also implies that a major fall in prices due to volatility may have a major impact on cash flows and profitability of the proposed project.
The uncertainty involved estimation of capacity factor
It is not possible to estimate the capacity factor with certainty due to changes in wind and probable repair and maintenance costs. Further, even though trends indicate an increase in capacity factor over last year, the capacity factor for the year 2018 was lower than the estimate provided by the supplier. If the actual capacity factor turns out lower than the estimate of 40% provided by the supplier, this will lead to a major decline in project cash flows.
Increase in the level of business risk
The company currently has a high level of business risk, which is evident from its higher unlevered beta. As the company is already subject to high business risks, further undertaking a wind electricity generation project which involves a lot of uncertainties will cause the business risks of the company to go high, which is not suitable for the future stability of the company.
Based on the results of the above financial evaluation techniques that were performed for this project, it is not worth undertaking the proposed project as it is not a profitable invest mention option for the company. The project would generate a negative net present value of $ 13.64 million which indicates that it is not suitable to undertake these projects. Also, as per the current cash inflows estimation, the internal rate of return of the project is 1 percent only, which is much lower than the required rate of return of 8 percent. Moreover, the payback period of the project is too long at 18.29 years. Moreover, the project involves a lot of uncertainties and would expose the company to very high business risks. Based on the consideration of all these factors, it is recommended that the company should not undertake this project.
CFI. (n.d.a). Net Present Value (NPV). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/valuation/net-present-value-npv/
CFI. (n.d.b). Internal Rate of Return (IRR). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-return-irr/
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