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CW2PPAI Solution and General Comments.

This assignment was designed to test your ability to apply some basic DCF
techniques to an evaluation of an investment in electricity supply and comment on an
alternative proposal thus implicitly drawing on the findings of the earlier evaluation.
The first point to note was that despite using a bold type face a significant number
failed to obey the instruction to draw the relevant cash flow diagram/s which should
be the first step in such exercises. Failure to do so may well have been responsible for
the conspicuous failure of some submissions to correctly interpret the question as set
and which thus leads to failure. You must answer the question.. One error was to not
apparently read the brief note to the effect that kW was a rate measure whereas kWh
is a quantity of electricity ie 1000 Watts flowing for a period of one hour. I was most
concerned about the adoption of a valid approach and inevitably some variations in
reported values arose based upon differing rounding assumptions but which should
ideally have been made explicit.
In general the first part eg cash flow and initial calculations a) and b) were done
reasonably well but a number of you seemed to rather fall apart in section c) where
you were asked to calculate the % price rise necessary to cover the cost escalation. In
essence this was merely a reverse calculation to those performed in class where a
price rise was combined with a discount rate to produce a net discount rate and I
was a bit puzzled as to why it seemed such a problem. More worrying however was
an apparent failure to recognise when a nonsense answer had been generated. It
should surely have been obvious that a price rise of around 3% would cover a cost
rise of around 3% and that further consideration would have led to the conclusion that
it should be a bit less than 3% given the dominance of generating costs and the fixed
cost of 100000 in the total cost. Thus any answer substantially adrift from 3% should
have aroused suspicions that an error must have been made!
The turbine option section produced a rather a mixed response and illustrated the
need to THINK about some basic implications and to make full use of information
from the calculations which included average power and also some valuable cost data
of grid supply with which the turbine would in effect be competing with. Again it
worried me that there seemed to be lack of common sense including references to
water freezing despite the question specifying a tropical location. .

a) The first part involves a basic application of the annuity formula applied to the cash
flows. The unknown is the annual quantity of electricity each kWh of which
contributes $0.02 (the difference between 0.12 and 0.1) in operating profit towards the
capital cost of the link and its maintenance. Letting annual electricity consumption be
E kWh per year then for a 32 year time scale the break even condition is;

0.1 x 10
6
+ {1000/0.1}[1- 1/(1+0.10)
32
] ={ E.0.02/0.1}x[1- 1/(1+0.1)
32
]
The annuity factor for n=32 and i=0.1 is 9.526 and thus solving for E yields .
E=~ 575000 (rounded)

b) Taking an infinite time frame the annuity formula reduces to 1/i (the terms in the
square brackets (above) reducing to simply 1) and hence the annuity factor now
becomes 10. Once again solving for E( which will clearly be lower than before) yields
E=550000 and change is around -4.3% Note that the difference between the n=32
case and the n=infinity situation is relatively small.

c) This section is a bit more complicated and requires several stages for the
calculation but in essence again involves equating discounted cost and revenue
streams to determine a new break even but where now cost have increased and the
unknown is the necessary % price increase. Again a cash flow diagram would have
helped clarify the situation.
1) We now revert to the original 32 year time frame and, using the same E as
previously calculated, work out the PV of the total costs for the new scenario where
yearly maintenance and generating costs increase by 5% and 3% respectively. The
present values can be calculated by combining the price escalation with the discount
rate to produce a net discount rate that may be used in the annuity formula . Thus to
a first approximation a 5% increase and a 10% discount rate results in a net discount
rate of approximately 5% (true value~4.76%) and annuity factor =16.26 and with a
3% rise close to 7%. ( true value ~6.80%) and annuity factor =12.91. The new
present value is around $861500 of which the majority ~86.5% is the generating cost.
but with a further 100000 unaffected by price rises (This permits us to conclude that
the answer will be in the region of 3% and indeed less than 3%.)

2) This present value has to equate with the PV of the stream of income being
generated from selling E kWh per year but where now the unit price of $0.12 is rising
by a fixed but as yet unknown % but which is combined with the 10% discount rate.
Thus 861500= 575000x 0.12E x annuity factor. This permits us to calculate that the
annuity factor is around 12.45 and this includes the combined effect of the unknown
% price rise and the known discount rate of 10% ie 0.1 We thus need to solve for d
(1/d).{ 1-1/(1 + d)
32
} = 12.45

3) There is no analytic solution to this equation since this is a high degree polynomial
in d but, as noted above, common sense would predict that d will be around .07
corresponding to an around 3% price rise to offset the 3% rise in generating costs.
Trial and error/linear interpolation as was explained in the of IRR calculations will
yield the desired result for d =~ 0.0715

4) The final step is to back substitute to calculate the actual % price increase (in effect
the reverse of the calculation used to generate the 4.76% values etc). ie solve for p,
the price rise, in (1+p)/1.1= 1/1.0715
Thus p=~2.66% As a check this value may be substituted back in the starting
equation to check for a break even..

(Note that 575000 kWh spread over a year ie 8760 hours represents an average
power of 65.6 kW compared to the specified capacity constraint of 150 kW.
which permits a peak demand of over twice average demand to be met. (In
reality consumption is not constant and with electricity storage being a problem
this is an important consideration.)








d) A stand alone run of river hydro power installation would eliminate the need for
both grid connection and fuel costs There would however be some maintenance costs.
The main difference is that now output depends on the water flow rate and the size of
the installed turbine and moreover supply is no longer being matched to demand
since output from the turbine will be will be continuous although not constant due to
flow rate variations . There may thus be a case for exploring facilities for electrical
storage or some use for any surplus power when conventional demand is low ie that
some load smoothing would promote a more efficient use. Note however that in the
original question a capacity for the grid link was specified of 150kW which implies
that the maximum quantity of electricity that could be consumed per year if the link
was used at its maximum capacity would be 8760x150 kWh =1.341 million.
If the potential generating capacity is particularly promising then a grid link that
would permit the export of excess power might be attractive or perhaps a link to a
neighbouring village community if relatively close by.
Some indication of the capacity can be gleaned from the earlier calculations since
in a year there are around 8760 hours and we have a value for E that can be used to
calculate the average power output ie E/8760. A key question is how much variation
there is both on a daily basis but also on a seasonal basis an issue mentioned at the
start. There is also the question as to forecasting how demand may grow since the
process of development tends to be energy intensive as processes are mechanised and
new activities undertaken. That said technological improvements in efficiency as for
example in lighting will help offset growing demand albeit at some cost and hence the
need for some imaginative solutions to assist developing countries as in the case of
the CDM (Clean development Mechanism) which might well apply in this case.
To provide a roughly equivalent supply a turbine of around 150 kW. capacity
would seem a reasonable starting point but the optimal size would rather depend upon
assumptions regarding flow rates, economy of scale issues and the relative costs of
storage to increases in installed capacity. In economic terms there is also some ball
park cost data available from earlier calculations which would provide a rough target
price for the turbine and its maintenance . Clearly a run of river is most appropriate
when water flow is reasonably reliable even though subject to variation and were a
river to regularly fall to a trickle then such a proposal would not be considered
appropriate. In short some common sense plus use of data from the earlier section
does permit some guestimation .

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