Cost-Benefit Analysis of an Oil Fuelled Power Station - Business Plan Example

April 2006 Cost- Benefit Analysis (CBA) of an oil fuelled power station Summary A cost-benefit-analysis has been taken up to assess the feasibility of setting up an oil fuelled power station. All costs in the form of fuel costs, other operational costs, environmental and health costs and dismantling and site restoration costs were considered along side the only benefit accruing from the project viz.sales revenue from the sales of generated electricity. A discount rate of 7% was chosen as an acceptable discount rate. The project was acceptable at this discount rate using the NPV technique .The project was found acceptable at this discount rate while conducting a sensitivity analysis by varying elements of costs and benefits. Sensitivity analysis also examined projects responses to varying discount rates. Background of the project An oil fuelled power station is to be constructed 20 miles west of Enree, a city of 1 million inhabitants. The information about the project is as follows: Construction Start Date 1 January 2010 End Date 31 December 2019 Total Construction Time 10 Years Construction Costs: For the first 5 years £250 million per year For the following 5 years £130 million per year Operating Costs: Fuel Costs in the first year of generation £90 million per year From second year of generation Increasing @2% per annum Other operating and maintenance costs through the operational life of the project £28 million per year Assumption of the Analysis: 1. Construction is completed in 10 years and there is no time over runs. 2. Once constructed, the station will begin immediate delivery of electricity, and will continue to do so (at a constant rate) over a period of 45 years from its first operation. Its operational life is 45 years. 3. Electricity generated would be sold entirely and there is ready market for it. 4. Therefore, the market price of electricity can be taken as an accurate indicator of its social value (exclusive of any external costs associated with its generation and use). 5. At the end if the 45 year generation period, the station is to be dismantled and the site restored. 6 There are no other impacts (adverse or beneficial) other than those stated in the problem statement. Revenues: Annual Electricity production 8,500 GWh Market price of 1kWh £0.059 Annual revenue from Electricity 8500X1000000X £0.059=£ 501500000 =£ 501.50 million Dismantling and site restoration Costs: Over three years after station ceases power output £200 million per annum Environmental and human health impacts: Adverse Health Impacts 100 extra premature deaths per year An additional 1000 hospital days per annum 5000 work days or days of good health lost per annum in surrounding population. Environmental impacts Reduction in wilderness amenity and existence benefits The above impacts to cost £20 million per year for 90 years from the time the station begins electricity generation. Task A Cost Benefit Analysis (CBA) of the above project has to be done given the assumptions and cost/revenue details. An appropriate discount rate is essential for conducting a CBA.In the following paragraphs we would detail the reasons for choosing a particular discount rate. Thereafter sensitivity analysis would be conducted varying critical parameters of the CBA to conclude if such variations do affect accept/reject decisions materially. It would be followed by an appraisal report covering the CBA and the sensitivity analysis. Choice of a Discount Rate The discount rate is the rate by which benefits/costs accruing in future project running period may be adjusted so that a comparison with present values is made possible. Conceptually this rate should be rate which is the equilibrium rate in demand and supply of savings in the present time. In order to save investors compare the value of current consumption to its future value and seek a rate of compensation required to curtail present consumption. An appropriate discount rate choice becomes important as funds are required for a large sized public project which seeks to increase social welfare of society at large. The funds are derived from public and their benefits would accrue to the public. In case a decision other than the correct decision is arrived at due to inappropriate choice of discount rate either the society would not have the benefits of the project or they would have the project but suffer more in terms of costs than benefits. Whereas the marketplace drives private investments, activities by the public sector can displace private investment(Module 4). Thus one parameter to include in a decision on an appropriate discount rate is to calculate and build in the time preference rate of consumers. Another parameter is to calculate and include in this rate the return expected in a typical investment analysis. Typical investors consider the rate of return they expect from a given investment, using methods similar to those used in arriving at capitalized values. In order to invest, the expected return on proposed investment should cover all costs, including the rate of interest. Under fairly restrictive assumptions, one can argue that investment will continue until returns across alternatives are the same and just balance the returns required by savers or marginal returns equate. Under equilibrium conditions one can theorize about existence of a single interest rate and a single rate of return on capital in the economy however in the real world capital markets a number of factors make possible several rates. The dilemma of a decision maker is which of these several rates to use in CBA.While private investments do build in expectations of inflation in clearing markets at a given rate in CBA exercise normally inflation aspect is avoided. For our purposes we have also avoided this aspect.Simlarly market interest rates reflect pre tax returns. We have presumed away even tax complications primarily because this is a social utility project. Market borrowers default and lenders bear the brunt. At the time of lending an element of reward for bearing risk and uncertainty of repayment is built in asked interest rates. Though diversification helps but systemic risk cannot be done away with. However in a public utility investment we can safely presume that it is the state that borrows and it should use a risk free discount rate in CBA as a sovereign because sovereign default is considered rare(Module 4). . Some argue that although it is possible to enumerate the reasons that make for multiple interest rates, which makes choosing a discount rate for CBA a tough ask. In the final analysis the discount rate chosen is often fairly arbitrary. Some lobbies wanting large state infrastructural and environmental investments argue for low discount rates while private sector lobbies seeking to drive out state participation roots for high discount rates. Mathematically higher discount rates will result in lesser number of projects having positive net present values. Strangely there is no definitive end to this debate. The guidance given for federal decision making by OMB is to use a 7 percent rate and to conduct sensitivity analysis using 5 and 9 percent rates (OMB Circulate). Some argue in favor of the lower riskless rate of time preference by individuals. Post tax rate as low as three percent, with basis in long term Treasury bonds yields may also be chosen. Others argue to raise this rate to limit mindless preemption of private capital. Yet others take a mid way stance. Assuming future growth rate of per capita income of 1 to 2 percent and an "elasticity of utility for marginal income of 1.5", one may reckon a rate of 1.5 to 3 %. Therefore for sensitivity analysis discounts rates ranging from 2% to 12 % are chosen and analyzed to reflect the entire range of private to public returns (Module 4). . CBA CBA has been done under following refined assumptions: (1) All costs and benefits are year end accruals. (2) Electricity generation commences in the year of completion of the project itself at full capacity. Similarly environmental and health hazards show up fully in the first year of generation itself to ensure their reckoning at their full monetary cost starting this year. (3) Dismantling begins only in the year 2065, the year after the last operational year 2064. (4) The power generation at full capacity is done and depreciation, obsolescence and decreases in efficiency and capacity utilization are ignored. (5) Effects of inflation on any prices are ignored. Methodology of CBA A costs and benefits chart has been prepared to cover the period year 2010 to the year 2109.The project completes in the year 2019.Till the year 2018 only construction costs are booked. Starting the year 2019 operation costs of fuel and maintenance have also been reckoned. These two costs run till the year 2064 when the rated operative life of the utility project of 45 years comes to an end. Environmental and health costs have been taken from the year 2019-when the operating cycle began and run for a period of 90 years-till the year 2109-as these costs have been presumed to have an impact till after the closure of operating life of the project in the year 2064.Dismantling and related costs have been shown booked for three years starting the year 2065 and ending in the year 2067. Electricity generation and its sales is the only revenue/benefit in the CBA.An annual calculation based on given electricity selling price and annual electricity generation has been arrived at £ 501.50 million per annum.Under assumption that all generated electricity is sold, this constant figure is booked as benefit/revenue for the 45 years operating life of the project starting from the year 2019 to the year 2064. Net benefits have been arrived at, year wise, by deducting costs from benefits for the entire period 2010 to 2109.The series of cash flows thus obtained was discounted at the adopted rate of 7% to arrive at Net Present Value(NPV).The project selection criteria was a positive NPV.The results are carried under appraisal. A detailed excel worksheet is enclosed as mentioned in appendix. Sensitivity analysis The above CBA analysis was subject to a sensitivity analysis in following manner. (a) It was tested under the case study conditionalities and results arrived for all discrete discount rates between of 2% and 12%.Decimal discount rates were tested in order to indicate an Internal Rate of Return(IRR) i.e. the discount rate at which the NPV of the cash flows turned zero. Since no hurdle rate was provided IRR was not used as a decision variable and arrive at just to show its magnitude. (b) Case study conditionalities were changed in a manner to test effects of changes in various costs and benefits. Subsequently same discount rates analysis was done for discounts ranging from 2- (c) 12% as in the normal case study conditions. This essentially threw insights into effect on NPVs of these changes at various discount rates. The full et of conditions under which CBA was tested can be tabulated as follows: (a) Case Study conditions (b) Case Study conditions with electricity selling prices rising 1% per annum-effect was to raise benefits (c)Fuel prices rise by 3% per annum-effect was to increase costs (d)Maintenance costs go up 1/2% per annum- effect was to increase costs (e) Health and environmental cost are reckoned at twice the current estimate- effect was to increase costs (f) Construction Costs are up £ 10 million per annum- effect was to increase costs We can now go in for final appraisal of the project. The appraisal includes the results of the sensitivity analysis as well. Appraisal The results thrown out by the NPV calculation under case study conditions are carried in Table I in appendix. The results show that the NPV of the project decreases with the increase in the discount rate. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 1071.98 million and thus can be taken up for implementation. At 5% discount rate the NPV is reported still higher at £ 1565.82 million. The NPV turns almost zero at a discount rate of 11.028 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 12% at which NPV is negative £ 133.14 million. The sharpest decline in positive NPV is seen when one changes the discount rate from 9% to 10%. Sensitivity Situation (b): Case Study conditions with electricity selling prices rising 1% per annum-effect was to raise benefits. The results thrown out by the NPV calculation under this situation are carried in Table II in appendix. The results yet again show that the NPV of the project decreases with the increase in the discount rate. Since benefits/revenue increases under this condition the NPVs at all discount rates have registered handsome gains. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 1575.13 million and thus can be taken up for implementation. At 5% discount rate the NPV is reported still higher at £ 3165.68 million. The NPV turns almost zero at a discount rate of 11.985 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 12% at which NPV is negative £ 2.08 million. It can be observed that revenue strengthening has raised the IRR of the project. Given a particular hurdle rate the project with strengthened revenue has better chances of getting selected. The sharpest decline in positive NPV is seen when one changes the discount rate from 10% to 11%. Sensitivity Situation (c): Fuel prices rise by 3% per annum-effect was to increase costs. The results thrown out by the NPV calculation under this situation are carried in Table III in appendix. The results yet again show that the NPV of the project decreases with the increase in the discount rate. Since costs increase under this condition the NPVs at all discount rates have registered substantial declines. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 592.39 million and thus can be taken up for implementation. One can observe the steep decline in NPV when compared to above two situations. At 5% discount rate the NPV is reported still higher at £ 1938.88 million. The NPV turns almost zero at a discount rate of 10.74 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 11% at which NPV is negative £ 38.54 million. It can be observed that cost worsening has downed the IRR of the project. Given a particular hurdle rate the project with worsened costs has hard chances of getting selected. The sharpest decline in positive NPV is seen when one changes the discount rate from 9% to 10%. Sensitivity Situation (d): Maintenance costs go up 1/2% per annum- effect was to increase costs. The results thrown out by the NPV calculation under this situation are carried in Table IV in appendix. The results yet again show that the NPV of the project decreases with the increase in the discount rate. Since costs increase under this condition the NPVs at all discount rates have registered declines but not by much because the cost undergoing change has an overall small size in the total costs of running the project. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 684.91 million and thus can be taken up for implementation. At 5% discount rate the NPV is reported still higher at £ 2193.00 million. The NPV turns almost zero at a discount rate of 10.995 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 11% at which NPV is negative £ 0.25 million. It can be observed that cost worsening has downed the IRR of the project but not by much as cost worsening took place in a small cost. Given a particular hurdle rate the project with worsened costs has hard chances of getting selected. The sharpest decline in positive NPV is seen when one changes the discount rate from 9% to 10%. Sensitivity Situation (e): Health and environmental cost are reckoned at twice the current estimate- effect was to increase costs. The results thrown out by the NPV calculation under this situation are carried in Table V in appendix. The results yet again show that the NPV of the project decreases with the increase in the discount rate. Since costs increase under this condition the NPVs at all discount rates have registered declines but not by much because the cost undergoing change has an overall small size in the total costs of running the project. As yet impact is greater than the maintenance cost situation as cost effects are greater. Since they occur even after the end of operating cycle and long drawn into time horizon impact is somewhat diluted. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 916.90 million and thus can be taken up for implementation. At 5% discount rate the NPV is reported still higher at £ 1963.09 million. The NPV turns almost zero at a discount rate of 10.560 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 11% at which NPV is negative £ 66.84 million. It can be observed that cost worsening has downed the IRR of the project but not by much as cost worsening took place in a small cost. Given a particular hurdle rate the project with worsened costs has hard chances of getting selected. The sharpest decline in positive NPV is seen when one changes the discount rate from 9% to 10% yet again. Sensitivity Situation (f): Construction Costs are up £ 10 million per annum- effect was to increase costs. The results thrown out by the NPV calculation under this situation are carried in Table VI in appendix. The results yet again show that the NPV of the project decreases with the increase in the discount rate. Since costs increase under this condition the NPVs at all discount rates have registered declines but not by much because the cost undergoing change has an overall small size in the total costs of running the project. As yet impact is greater since all affected costs are initial year costs. At the adopted discount rate of 7 % the project has a positive and high NPV of £ 627.75 million and thus can be taken up for implementation. At 5% discount rate the NPV is reported still higher at £ 2140.68 million. The NPV turns almost zero at a discount rate of 10.645 % indicating that a rate near this rate (at which NPV is exactly zero) is its IRR.Any further increase in discount rate would result in rejection of the project as exhibited by NPV calculation at a discount rate of 11% at which NPV is negative £ 189.64 million. It can be observed that cost worsening has downed the IRR of the project but not by much as cost worsening took place in a small cost. Given a particular hurdle rate the project with worsened costs has hard chances of getting selected. The sharpest decline in positive NPV is seen when one changes the discount rate from 9% to 10% yet again. In the above paragraphs we had seen the two common techniques for inter temporal selection of socially oriented project viz NPV and IRR.There are other techniques of getting to the selection decision. We define these techniques in brief in the following paragraphs. Pay Back Method: The payback method is easiest of measures to calculate and it is also the least consistent with the criteria of time value of money. The payback method essentially calculates how many time periods into the future does it take for a capital project to repay the initial investment. Its answers are in units of time. This method fails to account for all cost and benefit flows and does not cover risks. Discounted Payback Method: The discounted payback method seeks to improve one of the deficiencies of the payback method, by incorporating the time value of money. In this method the cost-benefit flows are discounted to reflect the value of time. The present value (the value of some future sum in todays money given a discount rate) is calculated for each of the cash flows using the present value formula. From these present values then payback is calculated as in the normal payback technique. Its answers are in units of time. This method fails to account for all cost and benefit flows and does not cover risks. Modified Internal Rate of Return: Modified internal rate of return is a technique that allows for the calculation of an IRR when negative expected cost-benefit flows occur after the start period. This method recommends compounding of all of the positive cost-benefit flows to the last period of project life and the discounting of all of the negative cost-benefit flows to the first period, at a given discount rate.MIRR decisions like IRR decisions require the specification of a hurdle rate. MIRR method results in elimination of possibility of calculating multiple IRRs which happens often enough when projects have negative cost-benefit flows late in their useful lives. It is still problematic to use in mutually exclusive projects or in situations of capital rationing. In short, any technique to be classed as an effective intertemporal selection technique must incorporate the time value of money, consider all cash flows and take into reckoning the risk factors. A comparative table of various techniques is furnished as under to end this appraisal: Technique Projects Independent Mutually Exclusive Capital Rationing Scalar NPV Effective Effective Effective Effective IRR Effective Not Effective Not Effective Not Effective MIRR Effective Not Effective Not Effective Not Effective Payback Not Effective Not Effective Not Effective Not Effective Discounted Payback Not Effective Not Effective Not Effective Not Effective Works Cited OMB Circulate A-94, http://www.whitehouse.gov/WH/EOP/OMB/html/circulars/a094/a094.html# Module 4:The choice of a Discount Rate.Retreived on April 14,2006 from http://sunsite.utk.edu/ncedr/tools/othertools/costbenefit/module4.htm APPENDIX OF TABLES Table I: Case Study conditions. Table II: Case Study conditions with electricity selling prices rising 1% per annum-effect was to raise benefits. Table III: Fuel prices rise by 3% per annum-effect was to increase costs. Table IV: Maintenance costs go up 1/2% per annum. Table V: Health and environmental cost are reckoned at twice the current estimate. Table VI: Construction Costs are up £ 10 million per annum A detailed worksheet in cbaeXCEL.xls enclosed as separate file. Read More