Analysis and Report of Powerco - Essay Example

?PowerCo: Your Analysis and Report Introduction This assignment deals with the feasibility and viability of the project considered by PowerCo. The project is about building up a generator, which would be used to produce electricity. In the beginning two years, the generator will be built. From third year, the generator will become operative and start providing the cash inflows. Cost of capital is assumed as 8% for this project. Discussion held subsequently emphasizes upon the present values of the cost of the project as well as the after-tax cash flows pertaining to the project. After then, Net Present Value (NPV) for the whole project is computed. Financial and non-financial risks factors are discussed while highlight the issues that may hinder the overall progress and benefits attached with this project. Recommendation is the last part of this report in which the discussion is provided which focuses on the acceptance or rejection of this project. 1. Present Value of Cost of Project The cost of building a new facility in the form of electricity generator is compromised on two years cost. The cost of first year is $25 million whereas the cost for the second year is $28 million. If the time value of money factor is set aside, the total cost of building such generator is $53 million. After discounting this cost with the cost of capital of 8%, the present value is found to be $50.93. The following is the supporting calculations used to compute the present value of building up the generator. Years Cost of Generator   Discount Factor (8%)   Discounted Value of Cost   Present Value of Cost 0 -25 x 1.0000 = -25.00 = -50.93 1 -28 x 0.9259 = -25.93     2. Present Value of After-tax Cash Flows It is expected that after-tax profits earned by selling the electricity would continue over a period of 9 years once the generator facility is built. By leaving out the factor of time value of money, the total profits earned in the form of cash flows from the generator amounts to $75 million. However, if cash flows pertaining to each year are discounted by the cost of capital of 8%, it decreases the value of $75 million a lot such that the present value is summed up to barely $47.16 million. The following is the comprehensive computation, which is used for calculating the present value of sales of electricity. Years After-tax Profits   Discount Factor (8%)   Discounted Cash Flows   Present Value of Cash Flows 2 6 x 0.8573 = 5.14 = 47.16 3 7 x 0.7938 = 5.56   4 8 x 0.7350 = 5.88   5 9 x 0.6806 = 6.13   6 9 x 0.6302 = 5.67   7 9 x 0.5835 = 5.25   8 9 x 0.5403 = 4.86   9 9 x 0.5002 = 4.50   10 9 x 0.4632 = 4.17     3. Net Present Value Net present value computed for the overall project is computed as negative $3.76. Net present value states the amount, which depicts whether the project provides the excess of cash inflows over the cost of building the generator facility after considering the element of time value of money. Following are the detailed computations for calculating the NPV of the project under consideration: Years Cost of Generator After-tax cash flows Discount Factor (8%) Discounted Cash Flows NPV 0 -25 1.0000 -25.00 -3.76 1 -28 0.9259 -25.93   2 6 0.8573 5.14   3 7 0.7938 5.56   4 8 0.7350 5.88   5 9 0.6806 6.13   6 9 0.6302 5.67   7 9 0.5835 5.25   8 9 0.5403 4.86   9 9 0.5002 4.50   10   9 0.4632 4.17   4. Risks The project of building up a new generator facility, which is expected to work for the next ten years bring several risk factors. These factors can be split into two major categories namely as financial and non-financial factors. Financial risk factors are given below followed by the non-financial factors. Financial Factors a) Cost of Capital One of the most important risk factors associated with such financial projections is the estimating the most appropriate cost of capital, which is used as discount factor to discount the cash flows and initial investment in order to compute the present values. It is extremely subjective to estimate the cost of capital and having the confidence that it will remain 8% for the next ten years, as there is likelihood the other economic factors might change which can bring a change in the cost of capital for the company. In case if the present values obtained today from by utilizing this cost of capital, then the original figures might turn out to be different than expected. b) Demand Forecast Due to the volatility of macroeconomic and demographic variables, it the demand forecast can be different. It would be quite difficult to estimate the electricity units to be consumed in the upcoming years as well as the rate against which these units would be charged. For that matter, the amount of cash flows can be differed with both the demand units as well as the rate per unit. c) Tax Rate Even though the tax rate for the given scenario is not provided, however, the amount of tax payment is subject to volatility especially in case of such long-term project. As the overall economy and fiscal prospects shape up, the tax rates are changed accordingly, which bring fluctuations in the actual cash flows therefore this risk factor carries the element of substantial volatility in the cash flows. Non-financial Factors a) Government Restrictions Change in the government policy or similar issues can create a problem for PowerCo, as they may restrict the company to produce only a specified amount of electricity units, or charge a different price, which is regulated by the government etc. This risk can substantially hurt the cash flow projections pertaining exclusively for this project. b) Competition The competition in electricity generation and supply industry can be cut throat in the upcoming years, as the more competitors will switch to this industry to reap profits. This may cause several problems to PowerCo because it may not charge the price that it wishes as well as cannot produce the electricity as per its own requirements. In this way, overall estimations of PowerCo regarding the building of new generator can be harmed significantly. c) Dependency upon Natural Resources to produce Electricity Since the electricity is produced by utilizing the natural resources therefore their demand forecasts, play a key role in shaping up the demand forecasts for electricity. Natural resources in the form of natural gas, furnace oil, and water provide different opportunities for the power producers to use them as per their needs. However, in case if the supply as well as the prices of these natural resources is deeply affected, then the cash flows estimated for the project can experience serious discrepancy. In any case, either the shortage in supply or price increase, it would be extremely tough for PowerCo to find out the other alternative energy resources in order to operate its generators. For that reason, the ultimate cash flows estimated today are subject to serious volatility, as cost of producing the electricity may not remain worthwhile. 5. Recommendation The decision whether to accept or reject the project, Net Present Value is the criteria, which is chiefly used. In order to accept any project based on NPV, and then NPV for that project should be positive in value. Conversely, if the project delivers the negative NPV figure, then the project should not be accepted, as it is no longer feasible and should be avoided. Since this project provides NPV of negative $3.76 million, the project should not be accepted at least on the financial grounds, as the project cannot increase the overall benefits in terms of healthy cash flows. However, if non-financial grounds suit PowerCo and it is probable that the overall economic conditions of the region will improve, then the viability of this project can be better shaped up for PowerCo. In that case, the company may accept the company may accept this project. References Fraser, L., & Ormiston, A. 2013. Understanding Financial Statements (10th ed.). Boston: Prentice Hall. Read More