A&H Chemical Corporation is a multinational manufacturer of industrial chemical products. A&H has made great progress in energy‐cost reduction and has implemented several co-generation projects in the United States and Puerto Rico, including the completion of a 35‐megawatt (MW) unit in Chicago and a 29‐MW unit in Baton Rouge. The division of A&H being considered for one of its more recent co-generation projects is at a chemical plant located in Texas. The plant has a power usage of 80 million kilowatt‐hours (kWh) annually. However, on average, it uses 85% of its 10‐MW capacity, which would bring the average power usage to 68 million kWh annually. Texas Electric presently charges $0.09 per kWh of electric consumption for the A&H plant, a rate that is considered high throughout the industry. Because A&H’s power consumption is so large, the purchase of a co-generation unit is considered to be desirable. Installation of the co-generation unit would allow A&H to generate its own power and to avoid the annual $6,120,000 expense to Texas Electric. The total initial investment cost would be $10,500,000. This would cover $10,000,000 for the purchase of the power unit itself—a gas‐fired 10‐MW Allison 571—and engineering, design, and site preparation. The remaining $500,000 would include the purchase of interconnection equipment, such as poles and distribution lines, that would be used to interface the co-generator with the existing utility facilities. 

As A&H’s management has decided to raise the $10.5 million by selling bonds, the company’s engineers have estimated the operating costs of the co-generation project. The annual cash flow is composed of many factors: maintenance costs, overhaul costs, expenses for standby power, and other miscellaneous expenses. Maintenance costs are projected to be approximately $500,000 per year. The unit must be overhauled every three years, at a cost of $1.5 million per overhaul. Standby power is the service provided by the utility in the event of a co-generation‐unit trip or scheduled maintenance outage. Unscheduled outages are expected to occur four times annually with each outage averaging 2 hours in duration at an annual expense of $6,400. In addition, overhauling the unit takes approximately 100 hours and occurs every three years, requiring another
triennial standby‐power cost of $100,000. Miscellaneous expenses, such as additional personnel and insurance, are expected to total $1 million. Fuel (spot gas) will be consumed at a rate of 8,000 BTU per kWh, including the heat‐recovery cycle. At $2.00 per million BTU, the annual fuel cost will reach $1,280,000. Due to obsolescence, the expected life of the co-generation project will be 12 years, after which Allison will pay A&H $1 million for the salvage of all equipment. 

Revenues will be incurred from the sale of excess electricity to the utility company at a negotiated rate. Since the chemical plant will consume, on average, 85% of the unit’s 10‐MW output, 15% of the output will be sold at $0.04 per kWh, bringing in an annual revenue of $480,000. A&H’s marginal tax rate (combined federal and state) is 36%, and its minimum required rate of return for any co-generation project is 27%. The anticipated costs and revenues are summarized as follows:

Initial Investment

Co-generation unit and engineering, design. and site………… $10,000,000

preparation (15-year MACRS class)

Interconnection equipment (five-year MACRS class)………….... $500,000

Salvage value after 12 years of use…………………………..… $1,000,000

Annual Expenses

Maintenance…………………………………………………….........$500,000

Miscellaneous (additional personnel and insurance)………......$1,000,000

Standby power…………………………………………………….....… $6,400

Fuel……………………………………………………………........ $1,280,000

Other Operating Expenses

Overhaul every three years…………………………………….... $1,500,000

Standby power during overhaul………………………………...…. $100,000

Revenues

Sale of excess power to Texas Electric………………………….... $480,000

(a) If the co-generation unit and other connecting equipment could be financed by issuing corporate bonds at an interest rate of 9%, compounded annually, determine the net cash flow from the co-generation project.
(b) If the co-generation unit can be leased, what would be the maximum annual lease amount that A&H should be willing to pay?