Situated in the foothills of the Himalayas is the city

Situated in the foothills of the Himalayas is the city of Amra, famous for the captivating beauty of its landscape and meadows. To give an impetus to the economic welfare of this region while given due consideration to environmental effects, the government of Pluton has encouraged industrial projects in this area for the manufacture of electronic products because of their non-polluting nature. In an Electronics Industrial Estate, about 200 electronic projects have been commissioned and another 80 projects are under implementation. Some plots are still vacant.

            The industrial estate is equipped with a 10 megawatt (MW) power plant to cater to the requirements of the industrial units as well as the nearby residential colony. On average, the power requirement is 50 kilowatts (KW) per industrial unit and 1,000 KW for the colony. As a result, there is a shortfall of about 1,000 KW of power, resulting in electricity rationing. Moreover, with the commissioning of an additional 80 projects within the year, this deficit would increase to about 5,000 KW.

            Under the new economic policy which allows the private sector to generate, transmit and distribute electricity, M/s. Koirala Power Company Pvt. Ltd. (KPCPL) has decided to set up a new power plant in the Amra industrial estate. The company belongs to a large diversified industrial group and has a great deal of experience in installing captive power plants.    

            Ms Durga Koirala, managing director of KPCPL, wants to find the optimal capacity of the power plant expressed in KW. The total cost of this power facility is made up of the capital cost of the power plant, the installation cost and the cost of fuel and maintenance. The relevant parameters are:

A2.             Investment Costs

1. Capital costs (CCi)

Capital costs (CCi) of the Power Plant are captured by the following equation:

CCi = CC0 * [(Xi/X0)^L + N * {(Xi/X0)^M ‑ 1}]

Where;

CCi      =    Capital costs for power plant of size i

CC0     =    Capital cost for the plant of base capacity = 100,000,000 LC

Xi =    Plant capacity      

X0 =    Base plant capacity = 3,000 KW

L, M, N are parameters:     

L    =    0.65

M   =    2.60

N   =    0.10

2. Installation costs
3. Installation costs (ICi) for a plant of capacity Xi are         

ICi =    IC0 *(Xi/X0) ^H

Where;

IC0 = Installation cost for plant of base capacity = 6,000,000 LC

H is a parameter: H = 0.025

A3. The costs of fuel and maintenance are as follows:

       Fuel cost (FC) per year,

       FCi = FC0*(Xi/X0)^K

       FC0 = 250,000*p, where p, the cost of fuel/litre, is 6 LC.

       K is a parameter; K = 0.90

       Annual maintenance costs are 5% of the capital cost of the plant.

A4.      Depreciation expense, residual value, and project life: Assume that the plant will have a useful life of 15 years regardless of the number of the operating hours per year. Straight line depreciation of the historical costs appropriately measures the declining value of this asset. Carry out your analysis for 10 years of plant operation.

A5.      Hours of generation per day: The plant will operate ten hours per day on average, since the customer electronics industry generally operates on single-shift basis.

A6.      Days of generation per year: The plant will operate for 300 days per year on average.

A7.      Tariff per unit of power: The company will charge LC 2.95 LC per kilowatt-hour. These rates are comparable to the existing tariff of government‑supplied power.

A8.      The discount rate is 10% per annum.

A9.      All values are in real terms.

ASSIGNMENT

As a consultant, you have been asked to help Ms Koirala determine the optimal plant size. You should evaluate plant sizes in steps of 500 KW.

1. Calculate the capital cost, installation cost, fuel cost, maintenance cost, residual value and receipts for the various scales. (Inputs sheet Line 138-143)

2.         Calculate the NPV and IRR for the project at various scales. Also calculate the NPV and IRR of each incremental investment (i.e. MNPV and IIRR[1]) required to increase the scale of the plant. Then answer the following questions:

       (a) At what scale is the NPV at its maximum?

       (b) At the scale in (a), what is the NPV of the incremental investment?

       (c) At what scale is the IRR at its maximum?

       (d)Which scale would you choose and why?

2.         Show in one graph the NPV, the IIRR, the discount rate, and the IRR of these projects as a function of the scale of the plant.

Hints

To obtain the NPV and IRR of the incremental investments (MNPV and IIRR), subtract the undiscounted net cash flows of scale S from the undiscounted net cash flows of the next scale (S+1).

Part B Timing

ESTABLISHING A LITHOTRIPSY CLINIC

Dr. K.V. Ganesan, director general of the Sanjay Gandhi Post Graduate Institute (SGPGI), Lucknow, is examining the feasibility of starting a lithotripsy service, utilising a process by which kidney stones are pulverised through shock waves without resorting to surgery. The process has become popular in other large cities over the past few years. The demand for treatment of kidney stones has been rising, and since surgical capacity is limited, there is already a long waiting list of patients with SGPGI.   

In view of the benefits of this method, Dr. Ganesan has obtained the approval of the governing body to establish a lithotripsy clinic with an adequate number of lithotripters and supporting staff. There are three different cost scenarios (see below), and the question before Dr. Ganesan is when to set up the clinic in each case.

In Year 1, the capital cost would be LC 65 million. Annual operating and training costs would be LC 4 million in Year 2.

The benefits of the lithotripsy clinic come from quicker treatment and the resultant increase in revenue to SGPGI. These benefits grow over time because of an expansion in market size that will occur independently of when the clinic is established. The benefits, amounting to LC10 million in Year 2, are expected to grow at the rate of 20% per annum.

Use a real opportunity cost of capital (discount rate) of 10%.

The three scenarios are as follows:

Scenario I: Neither the cost of the clinic nor the operating cost change over time.

Scenario II: Over time, lithotripters and accessories begin to be assembled in the country, leading to a reduction in capital cost at the rate of 10% per annum. Operating and training costs, on the other hand, are expected to grow at 3% per annum.

Scenario III: This is the same as Scenario II, except that with rising demand, indigenous manufacture of lithotripters accelerates, and the resulting economies of scale lead to a greater decline in the capital cost at a rate of 20% per annum. Operating and training costs, on the other hand, are expected to grow at 3% per annum.

For each of the three scenarios, calculate the following:

   (a)     The optimal year in which to invest.

(b)    The change in NPV, if any, if the project is implemented in the optimal year rather than in Year 1.

[1] Note that IIRR stands for Incremental Internal Rate of Return.