Asian Institute of Technology Dr.

Shobhakar Dhakal
School of Environment, Resources and Development 7 May 2014

Final Examination, January Semester, 2014

ED72.13: Development and Evaluation of Energy Projects

Closed-Book Examination Time Allowed: 3 hours

 The number in parentheses represents the allocated weight of the question.

 This exam makes 60% of total score

1. (2) Why inflation is necessary to consider in project financial analysis? How inflation is
generally measured/estimated?

2. (3) For prices that are incresing at an annual rate of 5% in the first year and 8% in the second
year, determine the ‘average inflation rate’ over two years (show step-by-step calculation
method too, do not just mention final number; hint: assume ‘x’ is price at year 0).

3. (2) In which context the constant dollar based project financial analysis is more relevant? What
about the context for actual dollar based analysis?

4. (2) If the project cash flow is given in ‘constant dollar’, which interest rate you must use in the
present worth calculation, choose one:
a) Inflation adjusted (market) interest rate
b) Inflation free (real) interest rate
c) None

5. (2) If the project cash flows are given in ‘actual dollar’, describe at least one of the ways (out of
the two ways we learnt in the class) through which present worth of the cash flows can be
calculated?
6. (5) A 15 year $50,000 bond that has a dividend rate of 10% per year is currently on sale and is
paid semi-annually. If the expected rate of return of the purchaser is 8% (inflation-free) per
year, comounded every 6-months, and if the average inflation rate is expected to be 2.5% each
6-months period, what does the bond worth now (a) without adjusting for the inflation and (b)
with inflation considered? Is the bond attractive?

Solution (a):

Number of coupon payments (n) = (2)(15) = 30

Value of each coupon/dividend payment (C) = (0.50)(0.10)(50,000) = 2,500

Bond price =
1
[1 − ( )] 𝑀
(1 + 𝑖)𝑛
𝐶× +
𝑖 (1 + 𝑖)𝑛

Where,

C = coupon payment = 2,500

i = yield to maturity = 8% = 0.08
n = bond maturity term = (2)(15) = 30 periods
M = par value or face value of the bond = $50,000

7. (2) When IRR-based project decision needs to be taken using ‘actual dollar’ cash flows, to which
interest rate this IRR needs to be compared for project acceptability? Choose:
a) Inflation free MARR
b) Inflation adjusted MARR
c) Interest rate by central bank
8. (3) Describe the key differences between sensitivity analysis, break-even analysis and scenario
analysis in financial analysis and highlight the strength/utility of each method?
9. (2) Explain key messages from below sensitivity graph (for risk analysis)
10. (2) Why economic evaluation of project is essential in energy projects? (2) How such evaluation
differs from financial evaluation in terms of objectives, proponets, costs and benefits, and input
and output prices? (2) What is the meaning of ‘shadow price’, how they differ from the market
price and why it is necessary to take shadow price in the economic evaluation of energy
projects?
11. (2) How the benefit-cost analysis framework to evaluate the public sector projects differ from
the private sector projects? (1) What is the interest rate used in such analysis called?
12. (2) In what instance ‘cost-effectiveness analysis’ is carried out as opposed to ‘benefit-cost
analysis’ in public sector projects? (2) What is the ‘cost-effectiveness ratio’? (2) What could be
the units of ‘cost-effectiveness ratios’ for ‘rural electrification options to improve electricity
access’ and ‘air pollution control measures for reducing public health risks’ (Hint: guess the
most plausible units of effectiveness)
13. (2) What are the key differences between equity and debt financing? (2) What are the major
financing sources for equity and debt financing? (2) Why companies often opt for debt financing
even if equity is available? (2) What is debt-ratio? (2) Why companies try to maintain targeted
debt-ratio despite benefits of debt financing?
14. (2) What are the key differences between ‘recourse’ and ‘non-recourse’ financing?
15. (5) A company needs to raise $20 mn for new unit in power plans. It targets capital structure of
0.4 debt ratio. The company has B =1.99 (B = stock price volatility of firm’s stock price relative
to market stock price as a whole), the risk-free interest rate is 6%, average market return is
13% (all are inflation adjusted). (a) Determine the cost of equity to finance new unit in power
plant (b) Determine the cost of capital if cost of debt is 6.92%.

(a) Cost of equity

𝐸𝑟 = 𝑟𝑓 + 𝛽(𝑟𝑀 − 𝑟𝑓 )
Where,

𝐸𝑟 = Expected rate of return or cost of equity = to be determined

𝑟𝑓 = Risk-free interest rate = 6%
𝛽 = Firm’s stock price volatility = 1.99
𝑟𝑀 = Average market return = 13%

Therefore, the cost of equity to finance new unit in power plant is

𝐸𝑟 = 0.06 + 1.99(0.13 − 0.06) = 𝟏𝟗. 𝟗𝟑%

(b) Cost of capital

𝑊𝐴𝐶𝐶 = 𝑤𝑑 𝑟𝑑 (1 − 𝑡) + 𝑤𝑒 𝑟𝑒

Where,

WACC = Weighted average cost of capital or simply cost of capital

𝑤𝑑 = Proportion or weightage of debt = 40% = 0.40
𝑟𝑑 = Cost of debt = 6.92% = 0.0692
𝑡 = Tax rate = 0
𝑤𝑒 = Proportion or weightage of equity = 100%-40% = 60% = 0.6
𝑟𝑒 = cost of equity = 19.93% = 0.1993 (from (a) above)

𝑊𝐴𝐶𝐶 = (0.4)(0.0692)(1 − 0) + (0.6)(0.1993) = 𝟏𝟒. 𝟕𝟑%

16. (5) Consider three public sector investment projects X, Y, and Z with same service life. If the
three projects are mutually exclusive, which would be the best alternative?
X Y Z
Investment cost, I $10,000 40,000 28,000
O&M Cost, C’ $ 8,000 16,000 2,000
Benefits, B $ 24,000 70,000 42,000
PW (i) $ 6,000 14,000 12,000