Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Fuelit plc is an electricity supplier in the UK. The company has historically generated the majority of its electricity using a coal fueled power station, but as a result of the closure of many coal mines and depleted coal resources, is now considering what type of new power station to invest in. The alternatives are a gas fueled power station, or a new type of efficient nuclear power station.

Both types of power station are expected to generate annual revenues at current prices of Sh.800 million. The expected operating life of both types of power station is 25 years.

Other information:
(i) Whichever power station is selected, electricity generation years time. is scheduled to commence in three

(ii) If gas is used most of the workers at the existing coal fired station can be transferred to the new power station. After tax redundancy costs are expected to total Sh.4 million in year four. If nuclear power is selected fewer workers will be required and after tax redundancy costs will total Sh.36 million, also in year four.

(iii) Both projects would be financed Eurobond issues denominated in Euros. The gas powered station would require a bond issue at 8.5% per year, the bond for the nuclear project would be at 10% reflecting the impact on financial gearing of a larger bond issue.

(iv) Costs of building the new power stations would be payable in two equal installments in one and two years time.

(v) The existing coal fired power station would need to be demolished at a cost of Sh.10 million in three years time.

(vi) The company‟s equity beta is expected to be 0.7 if the gas station is chosen and 1.4 if the nuclear station is chosen. Gearing (debt to equity plus debt) is expected to be 35% with gas and 60% with nuclear fuel.

(vii) The risk free rate is 4.5% per year and the market return is 14% per year. Inflation is currently 3% per year in the UK and an average of 5% per year in the member countries of the Euro bloc in the European Union.

(viii) Corporate tax is at the rate of 30% payable in the same year that the liability arises.

(ix) Tax allowable depreciation is at the rte of 10% per year on a straight line basis.

(x) At the end of twenty-five years of operations the gas plant is expected to cost Sh.25 million (after tax) to demolish and clean up the site. Costs of decommissioning the nuclear plant are much less certain, and could be anything between Sh.500 million and Sh.1,000 million (after tax) depending upon what form of disposal is available for nuclear waste.

Required:
(a) Estimate the expected NPV of EACH OF investment in a gas fueled power station and investment in a nuclear fueled power station.
State clearly any assumptions that you make.
(NB: It is recommended that annuity tables are used wherever possible)

(b) Discuss other information that might assist the decision process.
ANSWER
(a) Financial evaluation of the alternative power stations Gas fueled power station

Expected net present value 868.6 + 558.0 – (282.9 + 267.0 + 8.40 + 3.17 + 4.9) = Sh.860.23 million.

Notes:
(i) The interest cost is included in the discount rate
(ii) Decommissioning is assumed to have the same risk as the rest of the project
(iii) Discount rates

Gas Cost of equity using CAPM is 4.5% + (14% – 4.5%)0.7 = 11.15% WACC = 11.15% x 0.65 + 8.5%(1 – 0.3) x 0.35 = 9.33%

However, this is the nominal cost of capital which includes inflation. The cash flow projections exclude inflation and must be discounted at a real cost of capital.

6% will be used as the real discount rate.

Nuclear Cost of equity using CAPM is 4.5% + (14% – 4.5%)1.4 = 17.8% WACC = 17.8 x 0.40 + 10%(1 – 0.3) x 0.60 = 11.32%

8% will be used as the real discount rate.

These estimates of the discount rates assume that the value of the pound will not change relative to the Euro, or alternatively that the UK will join the Euro UK bloc in the near future. If this does not occur, and inflation differentials between the UK and Euro bloc remain similar, the cost of debt should be slightly less as the Euro is expected to fall in value relative to the pound.

Notes:
(i) If decommissioning costs Sh.500 million the expected NPV is Sh.1,558 million
(ii) For the purpose of selecting between alternatives the demolition costs in three year‟s time could be ignored

On financial grounds the nuclear alternative is expected to produce the higher NPV.

(b) Information that might assist the decision process includes:

(i) How accurate are the projected cash flows? Are the various revenues and costs likely to be subject to the same price level changes?
(ii) Is the risk of the project correctly measured the beta estimates?
(iii) What is the chance of significant changes in tax rates allowable depreciation?
(iv) Are there likely to be delays in construction?
How accurate is the estimate of the working life of the power stations? What happens if technology changes?
Is the technology well tested, especially for the nuclear alternative.

Sensitivity and/or simulation analysis to investigate outcomes under different assumptions is strongly recommended.

(vii) What will be the impact of the alternative levels of gearing on other activities of the company and on the company‟s share price?
(viii) What real options might exist with the alternative projects?
(ix) How significant are non-financial factors? In the light of nuclear accidents in Russia and Japan how safe is the nuclear alternative? How environmentally or politically acceptable

would this alternative be? Even if the nuclear alternative is the better choice financially, this might be outweighed non-financial considerations.

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