Incremental Investment Problems

1. Incremental Investment Problems ©Dr. Bradley C. Paul 2002 revised 2009 Note – the concepts shown in these slides are part of the basic body of common knowledge for those schooled in engineering economics. Material of this type appears in numerous text books no one of which was specifically followed by the author in the preparation of these slides.

2. The Incremental Investment Problem • Ever noticed that whenever some project or purchase looks likes its going to be a go, people come out of the wood work to add on • The salesman - for just a little bit more we can add on this feature. • Your partner - you say ok to $750 in furniture and they want the $825 set that is a little nicer • You engineer a good project and people start tacking extras all over it

3. Are the Add-Ons Worth While? • Can always redo the cash flow with the change and then analyze • trouble is you confound the add on with the original • how do you know if bad ideas are being subsidized from the success of good ideas? • Can suggest doing before and after NPVs but NPVs can get bigger because the projects is bigger • NPV could always stay positive even if the add on was a looser.

4. Standard Solution • Write down the cash flow of the project before the add on • Write down the cash flow after the add on • Take cash flow with the add on minus the cash flow before the add on (Big – Little) • Remember from the all cost alternatives problem that this gives you a cash flow that represents the advantage of choosing one instead of the other • In this case the advantage (or economics) of adding onto the project.

5. Finishing the Problem • Now do the NPV or other financial index (IRR, PVR, NFV etc) on the new cash flow • This will show you the value and costs brought to the total process by adding it on

6. Electric Utility Loads Over the course of a day the electric load on the power grid varies 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12

7. Loads vary with Season

8. Utility Implications • Baseload plants will run constantly. Their capital cost will be spread over many kilowatt hours of power, but operating cost, especially fuel will be critical • Tends to favor coal plants • Peaking Plants are just the opposite. Need to be cheap, quick to fire up. Operating costs are less important because peak power sells for a big premium. • Tends to favor gas turbines

9. Example Problems Mount Butterscotch Electric Owns an electric distribution system, but no power plants. With increasing power prices Mount Butterscotch believes that they can enter the generation business and make money for themselves instead of passing money on to others. Vanna Vanilla has proposed to the boss that they enter the market with a 400 megawatt power plant. The proposed plant would be powered by coal and would only be down for maintenance and running all the time except for that. Power would sell for 4.5 cents/KWH onto the bus bar. The plant would run 90% of the time. The fuel and maintenance for the plant would run 1.7 cents/KWH. The plant would cost $120,000,000 to build plus an annual payment for debt financing of $29,000,000 for 30 years (the estimated life of the power plant). The money would be spent over a period of 3 years with earnings and debt payments starting in the 3rd year. The company investors demand a 12% rate of return. Is Vanna’s boss likely to approve the project?

10. ………………. 0 1 2 4 5 6 7 8 29 30 31 32 $40,000,000 each year Drawing Pictures 3 $141,900,000 Electric Sales Revenue $59,300,000 Net Earnings each year $53,600,000 Operating Cost What Kind of Problem is This? $29,000,000 Debt Cost

11. ………………. 0 1 2 4 5 6 7 8 29 30 31 32 $40,000,000 each year What is this? Place the Pot and Identify Components $59,300,000 What is this? Money Pot $40,000,000 at time 0 drops straight to the money pot P/A12,2 * $40,000,000 P/A12,30 * $59,300,000 * P/F12, 2 What are we going to do about the money getting dropped short of the pot?

12. The Result • The NPV on Vanna Vanilla’s project was positive. - • Exercise for you - Calculate exactly what the NPV (and PVR) was on Vanna’s project. • Why Did I Want Both NPV and PVR? • A condition for a project to be considered is it must meet required rate of return – NPV is easiest check • Reality is that many times good projects have to compete with other good projects to see which one gets funded – the PVR provided us a bang for the buck comparison method. .

13. ………………. $72,700,00 0 1 2 3 4 5 6 7 8 29 30 31 32 $48,500,000 each year Now Out of the Woodwork! Tommy Topping decides that Vanna was too timid in her venture into the generation business and proposes that the power plant should be 500 Megawatts instead. Tommy Topping’s revenue projection is given below

14. ………………. ………………. $72,700,00 $59,300,000 0 1 2 0 1 2 3 3 4 5 6 7 8 29 30 31 32 4 5 6 7 8 29 30 31 32 $48,500,000 each year $40,000,000 each year What to do Next We could do an NPV on Tommy’s investment but the problem is that extra earnings from Vanna’s project could cover up for Tommy’s next increment being a bad idea. We apply incremental investment and subtract Vanna’s project from Tommy’s to see the merit of Tommy’s next project expansion over Vanna’s base case. Minus

15. ………………. $13,400,000 0 1 2 3 4 5 6 7 8 29 30 31 32 $8,500,000 each year The Incremental Cash Flow Do an NPV (and PVR) on this cash flow and find out whether Tommy really did top Vanna’s idea.

16. ………………. $81,400,000 0 1 2 3 4 5 6 7 8 29 30 31 32 58,800,000 each year More Ideas Ivan Moore has examined ideas by Vanna and Tommy. Ivan believes that the company should build a plant with two separate 300 megawatt units for a total of 600 megawatts. Ivan points out that designs by both Vanna and Tommy miss baseload generating opportunities because the equipment has to be turned off for maintenance. By building extra capacity that won’t run all the time they will pick up more baseload generation and pick up part of the cycling load. Ivan projects the cash flow below.

17. Moore Assignment Use the Incremental Investment technique to find out whether Ivan Moore’s next increment (from a 500 megawatt plant to a 600 megawatt plant) is Justified (look at NPV and PVR)

18. The Problem of Size • When a action is taken there is normally a fixed cost to it. • If you want a car there is a fixed cost to acquire, license and insure it • If you want a brick and mortar business there is usually a basic employee cost for someone who runs inventory and sales and records. • If I want to commercial farm there is basic equipment I need. • What happens if the cash flow from the business is small (because the business is little) relative to the fixed cost?

19. Economies of Scale • A second component of business cost is the variable cost – the more you do the more it costs • Might be like putting gas in your car – the further you drive the more gas you use. • Your licensing cost for your car stays the same whether you drive 100 miles or 100,000 • Your insurance cost varies a little but not much • As you get bigger your fixed costs get spread over more units of production • Your average cost goes down.

20. Economics of Economies of Scale NPV Zero NPV Line If your business is too small Your fixed costs will eat you For lunch. Size

21. Is Bigger Always Better? • Fixed Cost/ # units • This is not a linear function Diluting fixed costs with more production Runs out of steam.

22. Bigger is Better? • Markets may have finite size • What happens if the gold market trades 250,000 tons a year and I build a new mine that produces 400,000 tons a year? • In case of Mnt Butterscotch • If build coal plant that matches your base load it runs full all the time • If you get more capacity than your base load you will have to turn-down a very pricey power plant part of the time.

23. The Dis-economies of Scale • Ever tried to work with a company that was so big that no one knew what was going on? • First 400 ton mining truck • Had 3 axles to handle the weight • (of course it made it turn like an aircraft carrier) • No engine was available so they took a rail locomotive engine • (and had a truck with the pick-up of a switching yard train engine – come to think about it – that’s where they got the engine)

24. The Inventory Problem • Widgets cost $7.50 each to produce • You set a a batch and produce 100,000 a month for sales of 100,000 a month. • But with the Super-Duper Widget Producer it can be done for $6.50 each • You set up a batch and produce 5,000,000 • Problems – You have to get together enough raw materials for 5,000,000 widgets • Have to finance and buy it all • Probably need a place to store it all • It will take you 50 months to sell it all • You need warehouses • Your money is tied up • You have to adjust to market ups and downs by guessing far into the future

25. The Peaking Size Curve NPV Optimum Competing Project PVR PVR 1 NPV 0 PVR Opt Size Range Size

26. ………………. $83,300,000 0 1 2 3 4 5 6 7 8 29 30 31 32 74,700,000 each year Additional Office Stooges Riley Big believes in big coal plants. He proposes that the company should build an 800 Megawatt plant using two 400 Megawatt generating units. Riley points out his plan does everything that everyone elses does and moore. Riley shows that his plant can generate the cash flow below.

27. Making the Assignment a Riley Big Banana Split • The first part of your assignment was to get the NPV on Vanna Vanilla’s cash flow • The second part was to get the NPV of Tommy Topping’s next increment of power from 400 megawatts to 500 megawatts to see whether he really did get on top of Vanna’s project. • The third part was to check Ivan Moore’s next increment of power going from 500 megawatts to 600 megawatts and splitting to two 300 megawatt units. Use the incremental investment technique to find the incremental cash flow and then check the NPV on the next increment.

28. Finishing the Banana Split (your assignment) • Riley Big has proposed an even larger power plant at 800 megawatts. If Ivan Moore’s next increment is not economic, then Riley’s project need not be checked. If Ivan’s project made sense check Riley’s next increment above Ivan’s. Somewhere one of these next increments are not going to make sense because the capacity factor keeps falling for the next size up yet few economies of scale are being realized. • Indicate what size power plant Mnt. Butterscotch should build (build to the last economically justified increment, but don’t build an increment that doesn’t make sense. • For the last increment of power that did not make sense (its going to be Ivan’s or Riley’s) do an NPV on the total cash flow rather than the incremental cash flow. What answer would you got. Explain why incremental analysis leads you to make the correct decision about project size, while simply doing invest and earn problems for project sizing would not.