Evaluation of New Capital Projects at Yorkshire Wind Farm Company - Example

Evaluation of new capital projects at Yorkshire Wind Farm Company. Task Calculations Profit and loss account In order to study the Cash flow, it is essential that detailed profit and loss statements are prepared for both the projects (Baker and English, 2011). The statement is prepared by estimating relevant cost that may incur to the company. Figure 1: Profit and loss statement of small wind farm Figure 2: Profit and loss statement of large wind farm The capacity of each of the wind farms are: Small wind farm: 10 windmills with expected annual capacity of 60,000MWh. Large wind farm: 25 windmills with expected annual capacity of 120,000MWh. (MWh is short for Megawatt hour and is a unit of electricity output). A tariff of £50/MWh is what is the government is currently guaranteeing. Accordingly the revenue of each of the project is shown in the above profit and loss account, which is obtained by multiplying capacity with tariff. The government grant will be received in year 1. However it has been spread over the life of the project Adjustments to the above PL- However the above profit and loss statement does not incorporate the Annual management fees of £10,000 which the projects incur in the form of head office overheads. They must be included along with the annual management fees. Similarly the company the refurbishments in year 5 require the use of specialized equipment that will be borrowed from another division of the Company. This will cost the other division additional hire costs of £200,000 per project and is not reflected in the profit and loss accounts. This cost needs to be added with other energy costs. By incorporating both these changes the revised profit and loss account is shown below. Figure 3: Revised Profit and loss statement of small wind farm Figure 4: Revised Profit and loss statement of large wind farm Cash flow statement Figure 5: Cash flow statement of small wind farm Figure 6: Cash flow statement of Large wind farm Small wind farm is expected to earn a revenue of £3000 and large wind farm a revenue of £6000 (figures are in thousands) each year. The projected total expenses for each year has been shown taking into account the adjustments made to PL statement shown above. However in the cash flow statement depreciation has not been taken as an actual expense. Therefore there is seen to be a lower value of expenses in the cash flow statements above. Also it is to be noted that the pattern of net cash flows have remained same more or less for all the years except that the cash flows had gone down in the year 15 due to decommissioning. Capital Budgeting techniques NPV analysis Figure 7: Net Present Value Net present value discounts all cash flows at an appropriate rate to calculate their present value. The sum total of present values individually for each year is the net present value (NPV). This is consistent with the objective of a business wishing to maximise shareholder wealth (Bierman, and Smidt, 2007) Payback period Figure 8: Payback Period Payback period is the time period within which the initial cash investment is recovered through cash inflows anticipated to arise in the future. Accounting Rate of Return Figure 9: Accounting Rate of Return Accounting Rate of return refers to the rate of return based on which a particular project yields profits. It is calculated by dividing average profits with average investments. Internal Rate of Return Figure 10: Internal rate of return The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero. All projects with an IRR higher than the discount rate should be chosen Decision on the basis of Capital budgeting techniques Figure 11: Results of the above capital budgeting techniques Type Small wind farm Large wind farm NPV Accept Reject Payback Period Accept Reject ARR Accept Reject IRR Accept Reject Sensitivity Analysis The sensitivity analyses of the two projects are done by changing the output, price per unit and total expenses by +/- 10%. By changing the rate of MWh of power generated for each project by +10% Figure 12: Changes on NPV and IRR By decreasing the MWh of power generated for each project by -10% Figure 13: Changes on NPV and IRR By increasing price per MWh by +10% Figure 14: Changes on NPV and IRR By decreasing price by -10% Figure 15: Changes on NPV and IRR . By increasing the expenses by +10% Figure 16: Changes on NPV and IRR By decreasing the expenses by -10% Figure 17: Changes on NPV and IRR By increasing all data variables related cost (wind turbines, foundations, grid connection, refurbishment, decommissioning, cash reserves, total expenses and government grant) by +10% Figure 18: Changes on NPV and IRR By decreasing all data variables related to cost (wind turbines, foundations, grid connection, refurbishment, decommissioning, cash reserves, total expenses and government grant) by -10% Figure 19: Changes on NPV and IRR Task 2: Analysis and interpretation Results of sensitivity analysis Sensitivity analysis is the method by which variations in output are calculated and compared. This is done by changing each variable by a certain percentage and the results are compared with original figures to estimate the extend of change (Peterson and Fabozzi, 2004). It helps to measure the effects on NPV when a particular variable factor is changed by a certain percentage. Environmental conditions of a business are ever changing. Changing patterns of demand, price fluctuations and changes in productivity all have a significant impact on profitability. Hence this analysis must be conducted while analysis projects or while selecting projects that are mutually exclusive (Shapiro, 2008). For the given two projects, sensitivity analysis is done by changing three parameters, production capacity, price per MWh and total expenses. These changes are done on a scale of +/- 10% and their impacts on NPV and IRR are analyzed. When the capacities of the wind farms are increased, it is seen that the NPV of large wind farm is much greater than the capacity of small wind farm. The internal rate of return however is high for small wind farm than the large wind farm. So the result is contradictory. One the other hand when capacity of the projects are reduced by -10% it is seen that the NPV of small wind farm is less negative than that of large wind farm. IRR is however favorable for small wind farm. It is seen above that if price per MWh go up by 10%, NPV of large wind farm is higher. IRR in this case also is high for small wind farm. When the prices fall by 10%, NPV of small wind farm is favorable as it is less negative than large wind farm. IRR, however is still high for small wind farm When the expenses are increased by 10 % it is seen that NPV of small wind farm is favorable. Same goes with IRR. When expenses fall by 10% it is seen that NPV of small wind farm is lower than large wind farm. The IRR is however still high for small wind farm. Therefore it can be well observed how by making small changes in the costs effects the NPV and IRR. This helps to identify that if the estimated value based on which profit was calculated does not remain the same then it would have considerable effects on the projects. For instance it is seen that under normal circumstances the NPV of small wind farm is favorable compared to large wind farm, but under negative circumstances the NPV of small wind farm shows unfavorable results. Hence large wind farm might be considered better if there is decrease in price, Output and expenses. The concept of accounting states that companies should account for potential losses and not gains. Therefore the project that shows favorable results even under negative circumstances should be selected and in this case it refers to small wind farm. Analysis of capital budgeting Net Present Value-.The advantages of calculating net present value are that it takes into consideration the time value of money and helps to rank projects on the basis of higher NPV. This method takes the rate of discount as the cost of capital. Therefore it is important to calculate the cost of capital correctly. From the calculations below, it is seen that the NPV of small wind farm is higher in comparison with the large wind farm. Hence small wind farm project must be selected based on this method. Payback period- Generally the projects with longer pay back periods should not be selected. The advantage of using this method is that it is easy to calculate and incorporates all the cash inflows of the project spread over its lifetime whether they remain same or not (Chandra, 2005). On the basis of this method it is seen that the small wind farm project has a smaller payback period compared to large wind farm project. Hence on the basis of this method small wind farm project is one to be selected. Also it needs to be considered that the company expects that whichever project they undertake, should have a payback period not exceeding 8 years. Accounting Rate of Return- The main advantage of this system is that it is extremely easy to calculate. Ranking of projects can easily be done under this method. The project with an higher ARR is generally selected. (Dayananda et al., 2002). On the basis of this method it is seen that small wind farm generates higher ARR than large wind farm. Therefore small wind farm project should be selected. Internal Rate of return- It can be estimated using trial and error, or linear interpolation.The advantage of using IRR is that is takes into account the times value of money and all the cash flows. The cost of capital is not required to be calculated in this method (Drury, 2008). Based on this method it is seen that small wind farm is a better option as it yields higher IRR. Expected values When a company undertakes a new project or needs to select between mutually exclusive projects, it needs to forecast what returns the projects are capable of generating in the future. This is done by anticipating the future values of returns that may arise in respect of the project. Accordingly the project with the higher profitability is selected. The benefits of using such expected values for appraising projects are: 1. It involves forecasting; therefore any future loss or gains can be anticipated. 2. It helps to rank projects by analyzing which project can generate greater revenues in the future and has greater profitability. 3. It acts like a standard of appraisal. Management can use anticipated financial statements to compare actual results with forecasted values. Hence if there are differences, sufficient measures must be taken to sort them properly. Figure 20: Expected values of NPV and IRR In the above figure the expected values of NPV and IRR are calculated (refer spreadsheet). The base values are taken based on the calculations done previously and have been rounded off. By increasing and decreasing the base values by slight margin of +1000/-1000 in case of NPV and +2/-2 in case of IRR, the best and the worst cases are identified. By multiplying the NPV and IRR values thus obtained with the probability rates, the expected NPV and expected IRR have been derived. It is seen that total expected values are more favorable for small wind farm project than the large. Effects of inflation on the projects Inflation is the rise in the price of goods and services we buy. Since Yorkshire is in England where the inflation rate is normally seen to fluctuate in between 2% to 4%, a mean inflation rate of around 3% has been taken for this analysis. From the above Revised Profit and loss statement it is seen that the firm is expected to spend £1835 and £3810 (figures are in thousands) annually on an average basis. Hence if we take into account the rate of inflation every years expenses are supposed to go up by 3% as in order to obtain the same services the firm will have to higher on account of inflation therefore the company’s expenses are expected to rise as follows for consecutive 3 years, keeping year 1 as base. Figure 21: Inflation effect on net expenses. In this manner as long as the rate of inflation is at 3% the expenses of the firm will keep rising. In the above figure the expenses have been raised by 3% every year by calculating 3% of previous year’s value and adding it upon the total expense value of previous year. However during inflation the revenue of the firm is also expected to go up by 3%. Hence the rise in costs can be countered by the rise of revenue (FAO Corporate Document Depository, n.d.). Selection Decision From the above analysis of both the projects, through capital budgeting and sensitivity analysis, it is quite clear that the firm should adopt investing in small wind farm project. Although the capacity of the plant would be low, it is seen that the returns and profitability factor in this project is more satisfactory than large wind farm. By selecting this project the firm has to invest a lot less compared to large wind farm. This analysis reveals how important it is to appraise projects on the basis of capital budgeting before selecting them. Through capital budgeting it is possible to rank projects on the basis of their profitability (Pancholi, 2010). Reference List Baker, K. H. and English, P., 2011. Capital Budgeting Valuation. New Jersey: John Wiley & Sons. Bierman, H. and Smidt, S., 2007. The Capital Budgeting Decision. New York: Routledge. Chandra, P., 2005. Fundamentals of Financial Management. New Delhi: Tata McGraw-Hill. Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital Budgeting. Cambridge: Cambridge University Press. Drury, C., 2008. Management and Cost Accounting. London: Cengage Learning. FAO Corporate Document Depository, n.d. Chapter 6 – Investment decision – Capital Budgeting. [online] Available at: < http://www.fao.org/docrep/w4343e/w4343e07.htm> [Accessed 14 March 2014]. Pancholi, J., 2010. Financial Statement Analysis (2). [online] Available at: [Accessed 14 March 2014]. Peterson, P. P. and Fabozzi, F. J., 2004. Capital Budgeting. New Jersey: John Wiley & Sons. Shapiro, C. A., 2008. Capital Budgeting and Investment Analysis. New Delhi: Pearson Education India. Read More