Problem
An electricity supply company is responsible for ensuring that an electricity supply network is capable of supplying the expected electricity demand. Because of load increases a large component of the network needs to be upgraded now. A manufacturing company has entered into firm arrangements that will cause a large increase in the electricity load being supplied through the component in five years from now. The manufacturing company is committed to contributing a once off fixed capital payment of $6,000 toward the cost of the electricity supply network at that time. Inflation for the next 5 years is estimated at 6.1% p.a. The cost of funds for the company is 11% p.a. The planning engineers have refined the various proposals to the following: A. Carry out a major upgrade now at a cost of $12,060,000. B. Carry out a minor upgrade now at a cost of $2,349,000 and a further upgrade after 5 years at a cost, estimated in today's prices, at $12, 350,000.
A. Calculate the present values of these options with no risk factor. Which option should the company choose, on the basis of the present values?
B. If there was a 1 in 20 risk that the new electricity load will not eventuate and the capital payment will not be received, how would this affect the calculations? Which option should the company then choose? (If the company chooses A, and the new load does not eventuate, the extra capacity will not provide significant benefit for the foreseeable future.)