Wind Power Inc. builds and operates wind farms that generate electrical power using wind turbines. The firm has wind farms throughout the Southwest, including Texas, New Mexico, and Oklahoma. In spring 2015, the firm was considering an investment in a new monitoring system that costs $ 6 million per wind farm to install. The new system is expected to contribute to firm EBITDA via annual savings of $ 4.25 million in year 1, $ 2.9 million in year 2, and $ 1 million in year 3. Wind Power’s CFO is interested in investing in the new system but is concerned that the savings from the system are such that the immediate impact of the project is so accretive to the firm’s earnings that the individual unit managers will adopt the investment even though it may not be expected to earn a positive NPV. The firm has just moved to an economic profit– based bonus system, and the CFO fears that the project may also make the individual economic profits improve dramatically in the short term— a development that would provide an added incentive for the wind-farm managers to take on the project.
a. Calculate the project’s expected NPV and IRR, assuming that the cost of capital for the project is 15%, the firm faces a 30% marginal tax rate, it uses straight-line depreciation for the new investment over a three-year project life, and it has a zero salvage value.
b. Calculate the annual economic profits for the investment for years 1 through 3. What is the present value of the annual economic profit measures discounted using the project’s cost of capital? What potential problems do you see for the project?
c. Calculate the economic depreciation for the project and use it to calculate a revised economic profit measure following the procedure laid out in Table 7-8. What is the present value of all the revised economic profit measures when discounted using the project’s cost of capital? ( Hint: First, revise the initial NOPAT estimate from your answer to Exercise 7-3a by subtracting the economic depreciation estimate from project free cash flow calculated in Exercise 7-3a. Next, calculate the capital charge for each year based on invested capital less economic depreciation.) d. Using your analysis in answering Exercises 7-3b and c, calculate the return on in-vested capital (ROIC) for years 1 through 3 as the ratio of NOPAT for year t to in-vested capital for year t -1. Compare the two sets of calculations and discuss how the use of economic depreciation affects the ROIC estimate for the project.