The energy company believes that the probability of gas prices being ‘low’ in the next 15 years is equal to 40%.
The energy company is considering three options:
1) Build a Large capacity generation plant now.
2) Build a Medium capacity generation plant now and if gas prices follow the ‘Low’ scenario, consider the option of expanding the current plant to Large capacity in 5 years.
3) Become a member of an off-shore gas exploration consortium, which provides its members access to natural gas at low prices if new gas reserves are found. Overall, this increases the probability that gas prices follow the ‘Low’ scenario. After joining, the company still needs to decide whether to build a Medium of Large Capacity plant, using relevant information provided.
The Large capacity plant will cost £54.7m to build, will be in full operation after one year and will be able to produce a maximum of 100 MW/h (1 MW/h = 1000 kW/h), ie it will be able to generate electricity each hour it operates. Each year, it will incur operational costs of £2.38m and the plant and the land used for this site will have a residual value of £8.5m after the end of the project’s useful life. All prices are in real terms, ie they are expressed in today’s value of money.
The Medium capacity plant will cost £22.1m to build, will be in full operation after one year and will be able to produce a maximum of 40 MW/h. Each year, it will incur operational costs of £0. 86m and the plant and the land used for this site will have a residual value of £7.1m after the end of the project’s useful life. To expand the Medium plant, the energy company would need to invest an additional £40m in Year 5; in Year 6 and all subsequent years until Year 15, the expanded plant will have all the characteristics of the Large plant, as presented above (ie Production capacity, Operating costs and residual value). Again, all prices are in real terms, ie they are expressed in today’s value of money.
Membership in the gas exploration consortium would incur a payment of £10m that needs to take place at the same time as the investment (ie in Year 0); no other payments are required after that. The energy company expects that joining the consortium will increase the probability that gas prices will be ‘low’ from 40% to 60%.
The energy company has calculated its cost of capital to be 5.3% per year, again expressed in real terms.
Given the information above, what would you advice the energy company to do?
Additionally, the energy company would also like to see how the following changes in its initial estimates affect the results:
1) Plant Utilisation increases to 75% for both Medium and Large options
2) The fee for membership in the gas exploration consortium increases to £14m
3) The probability that gas prices being ‘low’ in the next 15 years is equal to 30% instead of 40%.
4) Operational costs for the Large capacity plant increase from £2.38m per year to £2.85m per year.
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