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SuperPower Corp. employs coal to generate electricity. The firm purchases the right to generate electricity for the next three years in Texas. Each year, SuperPower can produce 1,000 kilowatts. The cost of coal is $100 per kilowatt, and the revenue per kilowatt is $150. The price of coal is hedged and fixed at $100 for the next three years. The expected market risk premium is 7%. The risk-free rate is 3.0%. The average beta of power companies in the S&P 500 is 0.72.
1. What is the NPV of this project? What should they do?
2. Now suppose that SuperPower can use natural gas instead of coal at its convenience. The current price of Natural Gas is $100 to produce a kilowatt. With equal probability, the price of Natural Gas will rise 15% or fall 10% in each of the next two years. What is the value of the project? And what is the optimal strategy to use natural gas vs. coal? The beta of natural gas is 0.5. There are no costs for switching between coal and natural gas.
3. There is a cost for switching from natural gas to coal and vice versa. This cost is fixed at $30,000. What is the value of the project? And what is the optimal strategy to use natural gas vs. coal?
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