Imagine that the net present value of a hydroelectric plant with a life of 70 years is $23.73 million and that the net present value of a thermal electric plant with a life of 35 years is $18.77 million. Rolling the thermal plant over twice to match the life of the hydroelectric plant thus has a net present value of ($18.77 million) + ($18.77 million)/(1 + 0.05)35 = $22.17 million.
Now assume that at the end of the first 35 years, there will be an improved second 35-year plant. Specifically, there is a 30 percent chance that an advanced solar or nuclear alternative will be available that will increase the net benefits by a factor of three; a 60 percent chance that a major improvement in thermal technology will increase net benefits by 50 percent; and a 10 percent chance that more modest improvements in thermal technology will increase net benefits by 10 percent.
a. Should the hydroelectric or thermal plant be built today?
b. What is the quasi-option value of the thermal plant?