Reference no: EM13141143

A company is contemplating the purchase, installation and operation of a cogeneration system to offset the cost of utility-supplied electricity and natural gas used for powering and heating one of its facilities. The cogeneration system consists of a natural-gas-fueled heat engine that drives an electric generators that powers the facility, and whose waste energy is used to provide free heating to the facility. The system generates 200kW of electric power and supplies 300kW of thermal power to the facility. Its installed cost, including the waste heat recovery system is $2500/kW of electric power generation. It is anticipated that this system will run 8000 hours/year and will require a major overhaul every 5 years costing $1000/kW of electric capacity, as well as a $0.01/kWh of electric output for routine maintenance.

The fuel cost of operating this system amounts to $0.10/kWh of electric output (the waste thermal energy provides free heating), and the system is expected to last for 20 years and be sold at the end of the 20th year for a salvage value of $500/kW of electric capacity. If the cogeneration system is not adopted, the company will have to meet its electricity needs from the electric utility at $0.15/kWh of electric demand, and its thermal needs from the gas utility at $0.03/kWh of heating demand.

The Company, whose marginal tax rate is 35%, funds its projects from a pool of capital consisting of 40% debt at 8% annual interest rate and 60% equity at an annual rate of return computed by the CAPM. The annual risk-free interest rate is 4%, the SP500 annual rate of return is 9% and the Company's beta

(b) is 2.0. Assuming that all cash flows (except initial investment) are end-of year cash flows, use Sheet3A of the workbook MAE548MT1.xls to compute:

a) Compute the Return on equity, re, and the WACC for this Company;

b) Compute the cash flow for the 20 years for the cogeneration system as an increment relative to the avoided cost of utility electricity and natural gas;

c) Using WACC as a discount rate, compute the incremental pre-tax NPW of the Cogeneration System relative to utility-supplied electricity and natural gas fuel;

d) Determine whether IRR or MIRR should be used as an incremental pre-tax rate of return.

e) If MIRR is the appropriate metric, use an finance rate rf = WACC and a reinvestment rate, ri = re to compute the MIRR for this incremental investment;

f) Determine whether the investment in a cogeneration system should be undertaken (assume the MARR = WACC).