Section C

EcoGrid Utilities PLC

EcoGrid Utilities PLC is a public utility company evaluating a major investment in a new smart-grid infrastructure project. The project will last for 4 years.

Financial Data:

• Initial investment in infrastructure: $12,000,000, payable immediately (Year 0).
• The infrastructure will have a scrap value of $2,000,000 at the end of Year 4.
• Tax-allowable depreciation (capital allowances) is available at 25% per year on a reducing balance basis. A balancing allowance or charge will arise in Year 4.
• Initial working capital of $1,500,000 is required immediately. This will increase by inflation each year and will be fully recovered at the end of Year 4.
• Expected annual revenue in current terms (Year 0 prices) is $8,000,000.
• Expected annual operating costs in current terms (Year 0 prices) are $3,500,000.
• General inflation is expected to be 4% per year.
• Revenue is expected to inflate at 5% per year.
• Operating costs are expected to inflate at 3% per year.
• The corporate tax rate is 20%, payable in the year the profit is generated.
• EcoGrid's nominal (money) weighted average cost of capital is 12%.

Required:

(a) Calculate the nominal (money) Net Present Value (NPV) of the smart-grid project and advise whether EcoGrid Utilities PLC should proceed with the investment. (14 marks)

(b) Discuss the difference between nominal and real discount rates, and explain why the nominal approach was appropriate for this specific calculation. (6 marks)

**Part (a) NPV Calculation** *1. Inflated Revenues (5%) and Costs (3%)* Year 1: Rev = 8,000 * 1.05 = 8,400. Cost = 3,500 * 1.03 = 3,605. Net = 4,795 Year 2: Rev = 8,400 * 1.05 = 8,820. Cost = 3,605 * 1.03 = 3,713. Net = 5,107 Year 3: Rev = 8,820 * 1.05 = 9,261. Cost = 3,713 * 1.03 = 3,825. Net = 5,436 Year 4: Rev = 9,261 * 1.05 = 9,724. Cost = 3,825 * 1.03 = 3,939. Net = 5,785 *2. Tax on Operating Cash Flows (20%)* Year 1: 4,795 * 0.20 = (959) Year 2: 5,107 * 0.20 = (1,021) Year 3: 5,436 * 0.20 = (1,087) Year 4: 5,785 * 0.20 = (1,157) *3. Capital Allowances (CA) and Tax Shield (20%)* Year 1: CA = 12,000 * 25% = 3,000. Tax saving = 600 Year 2: WDV = 9,000. CA = 9,000 * 25% = 2,250. Tax saving = 450 Year 3: WDV = 6,750. CA = 6,750 * 25% = 1,688. Tax saving = 338 Year 4: WDV = 5,062. Scrap = 2,000. Balancing Allowance = 3,062. Tax saving = 612 *4. Working Capital (WC) (Inflates at 4%)* Year 0: WC needed = 1,500. Cash flow = (1,500) Year 1: WC needed = 1,500 * 1.04 = 1,560. Cash flow = (60) Year 2: WC needed = 1,560 * 1.04 = 1,622. Cash flow = (62) Year 3: WC needed = 1,622 * 1.04 = 1,687. Cash flow = (65) Year 4: Recovery of all WC = +1,687 *5. Net Cash Flows and Discounting (12%)* Year 0: Inv (12,000) + WC (1,500) = (13,500). DF=1.000. PV = (13,500) Year 1: Net 4,795 - Tax 959 + CA Tax 600 - WC 60 = 4,376. DF=0.893. PV = 3,908 Year 2: Net 5,107 - Tax 1,021 + CA Tax 450 - WC 62 = 4,474. DF=0.797. PV = 3,566 Year 3: Net 5,436 - Tax 1,087 + CA Tax 338 - WC 65 = 4,622. DF=0.712. PV = 3,291 Year 4: Net 5,785 - Tax 1,157 + CA Tax 612 + Scrap 2,000 + WC Rec 1,687 = 8,927. DF=0.636. PV = 5,678 NPV = (13,500) + 3,908 + 3,566 + 3,291 + 5,678 = +$2,943 (in $000s). Conclusion: The NPV is positive ($2.94m), therefore EcoGrid should proceed with the investment. **Part (b) Nominal vs Real Rates** A nominal discount rate includes the effects of general inflation, representing the actual market return required by investors. A real discount rate excludes general inflation, representing the pure time value of money and risk. They are linked by the Fisher equation: (1 + nominal) = (1 + real) x (1 + inflation). In this project, revenues, costs, and working capital were subject to different specific inflation rates (5%, 3%, and 4% respectively). Because cash flows inflate at different rates, it is impossible to discount them accurately using a single real discount rate. The only mathematically sound approach is to inflate each cash flow by its specific inflation rate to find the nominal (money) cash flows, and then discount these using the nominal WACC.