Financial Analysis Assignment: A Memorandum To ABC’s CEO For Project Expansion

Question

Task: The financial analysis assignment is based on the case information below. While the company and financial data in the case are fictitious, the context is not. Many companies face similar investment decisions as well as challenges and opportunities to run more environmentally and socially responsible businesses. Case Information

ABC Limited is a large agricultural producer that owns around one million hectares of land, most of which is used to run cattle bound for global markets. Recently, the Board and managers of ABC have been closely watching the rapid growth in popularity of meat alternatives, including imitation meat, and see it as a reflection of broader societal trends towards healthier lifestyles and reducing carbon footprint. The Board are concerned about the potential long-term negative impact of these trends on the company’s value and it has led them to reconsider the company’s strategy.

Given the size of the company’s land holdings, several alternative land use options have been considered. A move to the production of non-meat agricultural products has been ruled out because most of the company’s land is not suitable for the viable production of such products. Mining ventures have also been ruled out because none of the land contains a profitable level of resources except coal, which the Board has decided is not appropriate to deal with their aim to become a more environmentally responsible business. Coal is a hotly debated topic in energy and climate policy. The most recent proposal being examined by ABC is renewable energy production. Renewables are considered crucial in the transition to a low-carbon, sustainable future according to The International Energy Agency:

In 2018, renewable electricity generation rose 7%, with wind and solar PV technologies together accounting for 65% of this increase. Although the share of renewables in global electricity generation reached 25% in 2018, renewable power as a whole still needs to expand significantly to meet the SDS [Sustainable Development Scenario] share of almost half of generation by 2030. This requires the rate of annual capacity additions to accelerate… 1

Specifically, ABC are considering a wind farm2 . The company is now close to the final investment decision stage and the CEO has asked you to put together a financial analysis of the project. You will submit a summary of this analysis, along with your recommendations on the project, in a short memo.

The company owns several parcels of land that a wind study has indicated are suitable for power generation by wind turbines. One parcel in particular has been singled out as the best based on wind, geology, grid connection access, minimal environmental impact, local government consent and positive community attitudes in the area towards wind towers. Cattle currently run on this land but the company believes this activity would not be severely impacted by the wind farm. The stock would need to be removed during construction of the wind towers but existing stocking rates could be resumed once the wind towers are operational. Costs associated with this disruption in current activities during wind tower construction are estimated to be $0.2million net of tax effects.

In addition to the wind study, the company has incurred other project development costs, including for a geological study and environmental impact assessment, engaging the services of several relevant professionals, holding community consultations and receiving local government development approval. These project development costs have totalled $0.8m.

The wind farm will consist of ten, 2MW turbines, giving the wind farm a total rated capacity3 of 20MW. Each turbine will cost $2.2 million and related installation costs (including construction and grid connection, which are all depreciable) will be an additional $0.5 million for each turbine tower. The plant and equipment will be depreciated to a zero book value on using the prime cost method over 20 years. A proportion of the financing for the plant and equipment will be via a new 20-year debt issue, resulting in interest costs of $2 million payable at the end of each year. At the end of 20 years, the wind farm will be decommissioned and the plant and equipment sold for an estimated market value of $4 million. Estimated decommissioning costs are $3 million.

The rated capacity of the wind farm per hour (20MW) will not be available at all times due to winds that are lighter or stronger than the optimal wind speed range. Engineers from the turbine supplier have therefore suggested assuming a capacity factor4 of 40%, which means that the farm would be expected to produce 70,080 MW hours(MWh)5 of electricity each year, assuming continual operation. However, this is an uncertain estimate due to the variability of wind and the potential for repair and maintenance outages. Global capacity factors for onshore wind have been increasing over time, as seen in the graph on the next page, but the 2018 global average capacity factor was lower than the estimate provided by the turbine supplier’s engineers and there has been a wide range of achieved capacity factors each year.

ABC has negotiated a 10-year Power Purchase Agreement (PPA) that gives a guaranteed $40 per MWh. After this agreement expires, ABC assumes it will sell the electricity in the open market, starting with an estimated average price of $70 per MWh in the first year and increasing 3% per year after that. However, electricity prices are extremely volatile with a standard deviation of 40% of average price.

Source: International Renewable Energy Agency (IRENA) 2019, Renewable Power Generation Costs in 2018, IRENA, Abu Dhabi, p. 19.

In addition to revenue from selling electricity, ABC will qualify for a government scheme providing green certificates at a rate of one certificate per MWh of renewable energy produced. These certificates have value in the market for retailers who need to meet certain renewable targets. ABC will sell their certificates at the end of each year for an estimated $20 each. Based on expert opinion, ABC predicts that the government will end the scheme after 10 years when it is forecast to meet its renewable energy targets. The contract with the turbine supplier specifies that most service and maintenance of the turbines will be the supplier’s responsibility for 20 years. Therefore, operational costs are expected to be low. Variable operating costs are forecast to be $2 per MWh in the first year and increase at a rate of 2% throughout the life of the project. An additional $1 million annually in administration, insurance and general expenses (excluding depreciation) directly related to the project will also be incurred.

ABC has a 8% weighted average cost of capital and is subject to a 30% tax rate on its income. After some research and calculations, you have determined that ABC has a higher unlevered beta, adjusted for cash, then a pure play wind electricity generating company, listed on the same stock market as ABC. Unlevered beta adjusted for cash is a measure of business risk.

Required: Prepare (1) a spreadsheet financial analysis of the proposed project and (2) a memo to ABC’s CEO that briefly explains and justifies your chosen methods, inputs and any assumptions made, summarises your findings, and presents your recommendations on the proposed options. Ensure you not only analyse base case (expected) cash flows but also analyse and discuss potential uncertainty. Recommendations should address the decision to be made, along with any further follow up or other matters the company should consider prior to making a final decision.

Answer

MEMORANDUM
To: ABC’S CEO
FROM:
DATE: 10 MAY 2020
SUBJECT: EXPANSION OF THE PROJECT
The company mentioned herein financial analysis assignment is showing very responsible behaviour by not accepting coal and other products due to environmental concern. Solar power is the future of the energy industry and has good growth prospects. The decision of the management to go on with the project depends upon the benefits it will gain from the same. There are various investment appraisal methods that are used to decide the investment decision. The required rate of return is not mentioned so we have used the weighted average cost of capital as if the company is able to achieve the return of more than the cost of capital than it will generate value to the shareholders (Peirson et al 2015). As per the study, it has also been found that the required rate of return by the shareholders is higher as compared to other companies this would have inflated the weighted average cost of capital.

Thus the above analysis could not clearly give a green signal on the investment decision as the Positive NPV is a sign to go ahead with the project but IRR of 8.16% shows that the net benefit from the project will be just 0.16% above its cost. This is a very low margin as compared to the risk and work undertaken. The payback period is showing that the investment will be refunded by 10.81 years but this does not involve the discounting rate and after discounting the investment will be returned in the last year of the project which again makes it very risky and chances of changes arises due to such large span of time involved. As many factors are variable and thus further analysis of sensitivity and scenario analysis is done to get a clearer picture.

The NPV and IRR show the return or gain expected from the project taking the time value of money into consideration (Sherman 2015). Thus these are very important determinants for taking the investment decision. The payback back and discounted payback period also shows the time span by when the money invested will be received as a cash inflow, these are also normal as well as discounted cashback period (Carlon 2019). Though it avoids the cash flow after the payback period NPV has shown that difference and thus in the given case valuable information is generated from the same.

Uncertainty Analysis
The information as gathered is basically from the proper research still in some factors there is uncertainty involved. The development cost already incurred on research and permissions are excluded from the calculation as it is already incurred and even if the project is not started it is a sunk cost. The NPV is 0.37m which is not able to cover this development and thus taking this into consideration the project will not be able to gain benefit for the shareholders if the normal circumstances occur.

The second important variable is the capacity factor. This is the highest in the last 9 years. It is showing an increasing trend in the past years but not at the rate expected from the project. The highest capacity was 34% and the capacity taken in the project is 40%. This also depends upon the area and weather of the land as well as the advanced techniques used.

The uncertainty also exits at the price of the units in the market as in the initial 10 years fixed-rate contract is incurred later the deviation is 40% which is too high. The positive in this is that the expected price is also very high @ 70 per unit that means that even in the adverse case the fall of the price by 40%, will be higher from the already fixed unit price of $ 40 per unit. Thus though the volatility is high it is better than a fixed price agreement. The project would have negative NPV in case of a fall in the price and good positive NPV if price changes favorably.

The green certificates are also a very important part of the project which cannot be estimated accurately. As if the sale continues after 10 years than it would an additional benefit to the shareholders and on either case the loss would be incurred.

Sensitivity Analysis
In this, two cases are taken to analyze the sensitivity of the NPV of the project with some of its uncertainties as discussed above. First, a positive change is considered in the price of the unit. It is assumed that the price after the 10th year has increased by 40% over the estimated price of $70 and the company is able to achieve the 40% capacity factor. Thus NPV changes to $5.17m.

In the second calculation, it is assumed that the price after the 10th has decreased by 40% and also the company is able to achieve its capacity factor of 35% only instead of an estimated 40%. Thus this resulted in a negative NPV of $7.67m. Thus with a 40% change in the price, there is a huge change in the NPV of the project thus the project can be said to very sensitive to the price of the units.

Scenario Analysis
Since the discount rate taken for calculation is WACC which is affected by the high unlevered beta of the company so we have prepared NPV for two scenarios that are by changing the discount rate by 2% both upwards and downwards.

Now as per assumption on scenario basis

Conclusion
The project is in the neutral position as the NPV is very low and any changes in the variables would directly make the project unfavorable for the company. The company may consider the following points for the project.

1. The company does more research and analysis about the expected future price as the variance 40% is too high and either the fixed contract agreement may be entered or some other method to get the minimum payment so that a more reliable estimate can be done.
2. The company should also do some self-research or take some professional advice for determining the capacity factor as depending on their engineers is not good and private professionals should be approached as it looks more volatile as per the past trends.
3. The company may also analyze its competitive advantage in the market and factors affecting as its beta is higher than the general rate in the industry.
4. The discounting should be properly determined using the corrected beta as per the discussion in Pt 3.
5. The management should negotiate for more cost reduction as the IRR is very close to the WACC and this would increase the revenue for the company.

The project even though it is neutral still can be accepted the normal activities which are occurring now are not disturbed and thus is the additional option available with the company.

References
Carlon, S. (2019). Financial accounting: reporting, analysis and decision making. 6th ed, Milton, QLD John Wiley and Sons Australia, Ltd

Peirson, G, Brown, R., Easton, S, Howard, P. & Pinder, S. (2015). Finance, Financial analysis assignment 12th ed. North Ryde: McGraw-Hill Australia.

Sherman, E. (2015). A manager's guide to financial analysis : Powerful tools for analyzing the numbers and making the best decisions for your business (6th ed) Ama Self-Study

Appendix
Base case

Pessimistic case