Case Study of the Western Company
The Western Company is a public utility holding company which builds and helps to operate electric generating plants across the world. Western is facing increasing competition as the utility Industry moves toward deregulation. In the past Western has relied on engineers to make key decisions In the area of capital budgeting selecting projects with the lowest present value of future costs. This Is a continuation of the previous case In which the managers are now using the actual company projects to learn new methods of valuation. 1.
Classes 9 a. I do not agree with the decision made by the analyst regarding the natural gas project.
Assuming the 4 percent inflation premium holds true, the increase in revenues will outpace the increase in operating costs, resulting in greater profitability. In the analysts figures they used an inflation adjusted rate without adjusting the cash flows for inflation causing an undervaluation of the project. 2.
Classes 10 b. By using the NP calculation, Western Is only using the known Information In an all or nothing scenario. While useful In passive Investing, such as the bond racket, this type of calculation leaves out many factors in the budgeting for projects.
By using NP, the firm is ruling out the active management of projects, and the decisions that can accompany that management. In the management of projects there are always options available: the firm has the ability to sell the project, abandon it, invest further, or wait and see.
The value of an option is that it allows the firm to deal with the uncertainty in a flexible manner and then generate the expected value of a project. 3. Classes 11 c. Western should proceed immediately with the pipeline project. In either scenario the project has a positive NP.
While the NP to delay is significantly greater than the NP to proceed, the benefits of Increased Inflation will still be felt If the project proceeds. Therefore, Western should take the lower present Minimal cost of investment. 4. Classes 12 d. Under the conditions set forth, without the possibility of varying conditions or abandonment, it is not recommended the firm move ahead on the project.