Please answer these questions from the below study. Make sure to answer all three questions and include any table, recommendations, the key numbers, the underlying rationale, key tables and other supporting information; and if required, an appendix that contains supporting analysis and information.

1. What electricity tariff should WWPs bid propose? If WWP wins the bid, what is the value of the

project to the firm? How did you arrive at these numbers?

2. How should the project be financed? What are the implications for WWPs capital structure and

cost of capital? How did you arrive at these conclusions?

3. Should WWP hedge the first year of its cash flows? If so, what hedge ratio would you

recommend? How did you arrive at this conclusion?

CASE STUDY: A MEXICAN POWER PROJECT

Western Wind Power (WWP) is a renewable energy company that builds and operates wind power

farms. Currently, its operations are located in Colorado, Utah, and Wyoming. However, the reforms in

the Mexican power sector in 2012 generated a lot of opportunities for investment in electricity

generation and distribution, and the firm is currently considering whether to undertake a project south

of the border.

WWPs Current Operations

In its US operations, WWP focuses on operating wind farms owned by third parties. It has several long-

term contracts with US power companies and municipalities.

Several years ago, WWP also earned significant revenues from constructing wind farms for third parties.

However, this business has been stagnating recently; WWP has not received a new construction

contract in five years. After the 2016 presidential election, US energy priorities shifted, and WWP does

not expect any new US businesseither construction or operationsin the foreseeable future.

WWP has paid down its debt over the years. It leases most of its equipment, which limits its need for

capital. In previous years, deferred payments from previous construction projects (long-term notes

receivable on the balance sheets) have matured, and WWP holds a considerable amount of cash on the

balance sheetfar more than it needs to run its existing operations. If it fails to win new projects, WWP

will face pressure to return this cash to its shareholders. WWFs recent financial statements are

attached below.

WWP is a privately held company. It was founded by Dr. Sharma, who owns 28% of the shares and is the

CEO. The remaining shares are held by family members and senior executives in the company. Dr.

Sharma is an experienced engineer, with a PhD from the University of Illinois. She doesnt have time for

financial details. From her conversations with shareholders, she feels that the required return to equity

is about 10%. She recognizes that this is low, but thinks it is justified. Were in a cyclical business, but

we dont have any debt.

Dr. Sharma is willing to take on a project in Mexico, even if it increases the firms risk profile, and even if

it requires changing the firms capital structure. However, she will only do so if its worth a lot to the

firm. After discussing this statement with her, you feel thats she would OK the project if it raises the

value of the firm by at least USD 4-6 million.

The Mexican Power Project

The project in Mexico is a form of private-public partnership, known as a PPP project. The terms of the

project have been approved by the National Energy Control Center, the regulator for Mexicos electricity

sector.

A company is eligible to submit a bid for the project if it can demonstrate expertise and experience in

the field of wind power, and if it has sufficient financial capacity to construct the proposed project. After

several meetings in Mexico City to discuss WWPs capabilities and balance sheet, WWP has been

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approved to submit a bid. The differentiating feature of each private companys bid is discussed in item

(3) below.

The private company that is awarded the contract will:

(1)

Construct the wind farm, using its own funds or funding from private markets. The farm will need to

maintain minimum capacity of 40 megawatts.

(2)

Retain ownership of the wind farm and operate it for 20 years.

(3)

Sell electricity generated by the wind farm to the local power distributor, Jalisco Light and Power

(JLP). JLP is a new entity, and does not have a credit rating. However, your finance department

believes its credit rating would be two or three notches below that of the Mexican government.

Each firms bid will propose an electricity tariff, which must be quoted as Mexican pesos per

megawatt hour (mwh). JLP will purchase electricity from the wind farm at this tariff for the first year.

Afterwards, the tariff will increase each year at the rate of Mexican inflation. The firm with the

lowest proposed tariff will win the contract.

(4)

JLP guarantees a minimum purchase of 75,000 mwh per year. It may purchase more than that,

depending on electricity needs in the province.

(5)

At the end of 20 years, ownership of the wind farm and all of the wind turbines installed upon it will

pass to JLP. JLP will pay no compensation for this, and will operate the wind farm thereafter.

(6)

According to a written agreement with the Mexican government, the project will be completely free

from Mexican corporate income taxes.

Thoughts from WWPs Engineers

For the Mexico project, WWP plans to install large wind turbines produced by Shanghai Greentech, a

Chinese company. Each turbine has capacity of 3 megawatts; the purchase price is USD 3.2 million

(including shipping and tariffs at the Mexican border). Installation costs are estimated at USD 310,000

per turbine. The wind farm could begin operation about one year after the contract is signed.

Your engineering department explains that a single wind turbine, operating at full capacity for one hour,

will generate electricity equivalent to 3 megawatt hours. However, a wind turbine will only occasionally

operate at full capacity. Sometimes, depending on the season or the day, there will not be enough

demand for electricity. And sometimes there wont be enough wind.

After a careful study of the location, your engineers believe that a single 3 megawatt wind turbine could

produce, at most, 11,750 mwh per year.

Your engineers believe that a sensible way to estimate operation and maintenance (O&M) costs is as a

percentage of the purchase price (excluding installation costs), taking into account that both O&M costs

and the purchase price will increase over time with inflation. For the five years, O&M costs should total

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3% of the purchase price per year; roughly half of this is imported parts, priced in US dollars, and half is

local labor and parts, priced in Mexican peso. After that, O&M costs should rise to 5% of the purchase

price per year.

Thoughts from WWPs Energy Consultants

WWP hired an energy consulting firm (Global Energy Associates, or GEA) to provide expert views on the

sector and the project.

GEA notes that wind-generated electricity is unlikely to be competitive compared to other forms of

generation. It notes that coal-fired electricity is available in the region at a price of 620 Mexican peso per

mwh. However, it also notes that regulations require JLP to purchase one-third of its electricity from

renewable sources, such as wind power. Since there are few renewable options, GEA believes that, if

necessary, the wind farm can price its electricity significantly above its coal-fired competition.

GEA expects the wind farm to sell 95,000 mwh of electricity in the first year; this amount is expected to

increase at the growth rate of the Mexican economy.

Thoughts from WWPs Finance Department

You are the Chief Financial Officer of WWP.

Youre unable to obtain financing in Mexican peso. Youve held several discussions with international

banks, who are willing to provide a 20-year, US dollar loan, backed by the projects cash flows. The

interest rate depends on the amount of the loan. For a loan less than or equal to 30% of the projects

upfront cost, the lending rate would be 4.50% fixed. For a loan above 30%, but less than 60% of the

projects upfront cost, the lending rate would be 6.25% fixed. No bank will lend beyond 60% of the

projects cost.

You have also looked into the issue of using forward contracts to hedge the projects cash flows.

Unfortunately, you are only able to hedge one year at a time; it is too costly and will require too much

margin for WWP to hedge beyond that.