Question: Expedic Utility Corp needs to increase its electricity production capacity

Expedic Utility Corp. needs to increase its electricity production capacity. It is interested in a slightly used reactor located in Ontario. It has been offered two alternatives: buy the reactor for $16 billion (and hold onto it for 20 years) or lease it for 10 years at $2.5 billion per year. At the end of 10 years, Expedic would have the option of either buying the reactor for $3.5 billion or renewing the lease at annual payments of $3 billion. Expedic has a cost of capital of 7 percent. Assume the economic life of the reactor is 20 years, the CCA rate is $800 million per year, and the tax rate is 40 percent. At the end of 20 years, the reactor will have a salvage value of zero. Assume all lease payments are made at the beginning of the lease; all leases are operating leases; maintenance costs of $12 million per year will be covered by the lessor; and all CCA is taken at the end of the year (do not apply the half-year rule).
a. Draw the decision tree for Expedic. What choices does it have to make and when?
b. Ignoring the real options value, evaluate the NPV of the three alternatives: 1. Buy asset; 2. Lease and renew lease in year 10; and 3. Lease and then buy asset in year 10. What is your recommended course of action to the CEO of Expedic?

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  • CreatedFebruary 25, 2015
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