Case Study: Application of Real Options to Energy Investments

“When AES undertook primarily domestic contract generation projects where the risk of changes to input and output prices was minimal, a project finance framework was employed.”

Behavioral finance theories, which are based on the psychology, attempt to understand how the psychological variables (heuristics, prospect, and herding) and perceived risk behaviour (Risk Perception, Risk attitude and Risk Propensity) influence individual

Escalating costs played a major role in the diminishing number of power plants in the United States. (Cohen, 1990). Plants completed in the 1970’s carried an average price tag of $170

1. What does a financial analysis of Rawlinson’s options reveal? Assume that Rawlinson has a $500,000 budget and Porsche dealers and Porsche Canada earn a margin of 15% each on its winter equipment.

Each year the cost of designing, building, and maintaining renewable energy infrastructure and technology decreases. This trend is most prominently visible in the solar and wind industries which have both “seen stock prices jump since Congress approved an extension of tax credits for renewables” in late 2015 (Warrick). One cause for the renewable industry’s growth is the influx of investors. In November 2015, Goldman Sachs “quadruple[d] its investments in renewables to $150 billion,” a trend that has only become more prevalent in 2017 (Warrick). Part of the strong appeal of renewable energy is that it pays itself off over time. Instead of paying an electric bill every month, year after year, one can pay to have solar panels installed, that while initially expensive, never require additional payments. Not only are they free after the initial payment, some electric companies pay customers for installing panels and investing in clean energy. Many people complain that renewables produce far less power per dollar than coal, natural gas, and oil. While this may be true, the gap is quickly closing as renewable technology improves and prices drop. The convenience of only needing to pay once for renewable infrastructure far outweighs the greater power output that non-renewables provide for

Continued investment should be encouraged in order to develop the best technology in energy for the future. Continued investment will allow for new and exciting developments that will improve the energy industry in the long run. It will assist the industry in satisfying the growing demand and need for sustainability. There are a number of political and legal factors that are significant to the energy industry. For example, laws and government regulation on energy use could potentially affect the demand for domestic energy and thus lead to a shift in prices. However, with an increase of clean energy use, the demand for energy will not change dramatically due to laws and regulations, instead, the future prosperity of the globe will improve.

This approach allows for valuing real assets with some degree of operating flexibility, incorporating the value of the flexibility into the option price. It values the option to exercise but not the obligation to make future investments. It is based on the law of one price (the price of two portfolios with the same cash flows in every state of the world must be the same). Option value increases with great uncertainty (see Exhibit 3). The major uncertainties are Arundel Partners’ WACC and volatility of return on assets. A sensitive analysis shows the degree of changes with the changing uncertainties. The major disadvantage of this approach is that it often requires changes in business process. In Arundel Partners’ case, the terms and provisions in the contract will mitigate some of the disadvantages.

Firm’s value maximization managers must have check on internal capabilities for external opportunities. Managers can get real option value by doing decisions on time and flexible about firm’s opportunities and capabilities. There are four main parts in the manager’s work box for investment valuation opportunities.

A financial model is a spreadsheet representation of an asset designed to forecast financial results. A change in a variable, or input, alters the model’s result. Similarly, the process of changing variables and altering the results is a straightforward form of sensitivity analysis. Linneman (2011), under the heading: THINGS CHANGE FOR A REASON, cautions “Students and young professionals [that] generally put too much emphasis on numbers and not enough emphasis on the reasoning behind the numbers" (p. 71). The author advocates that economic assumptions and critical thinking are required for authentic sensitivity analysis, as opposed to just plugging in numbers. Nonetheless, Linneman (2011) does admit that “smart investors… with similar information, frequently arrive at drastically different valuations because they perceive differ[ing]ent degrees of risk and opportunities” (p. 71).

The future cash flows of MW’s reserves contain a great amount of risk and have many possible future outcomes. The real option valuation method takes into account the flexibility rising from this uncertainty. Real options often are valued using financial-option pricing techniques. However, there are several things to be considered when treating reserves as options by using more specific Black & Scholes model.

options should be weighed to decide what is the best option for the individual.An underlying

Cost Benefit Analysis. For an option to be a viable solution its benefits needed to convincingly outweigh its cost, best established by a cost benefit analysis.

Currently, new investments in low-emissions generation does not costcompetitive with the current generation (which high initial capital costs now sunk). This, along with the ability to excess supply in the NEM and barriers at the exit of the current generator, which means that the current generators can operate for some time. This means that there is an incentive to invest in reducing emissions of new (or any other) generation of electricity. There is a need for a policy to limit emissions intensity of the display. RET and accelerate deployment of renewable electricity generation. This can increase the acceleration of policies that create a low emissions generating additional demand. It is important that policies and incentives, stable, due to the long life of power generation assets. Deployment of low-emissions technologies, such as geothermal energy and CCS emerging, high risk and capital intensity. There may be a need for public support or policy to make the publication of these financial technologies, unless additional income available source. In addition, technology, price and logistical problems delayed the progress of these special techniques in recent years. As a result, experts from the electricity sector in general, do not expect to contribute significant

Introduction The purpose of this analysis is to make a determination about a project that the PowerCo is considering. The project runs for twelve years. The discount rate is 8%. There are costs for the first two years and then there are net positive cash flows for the subsequent ten years. A net present value calculation will be used in order to determine if the company should undertake this project or not. The present value calculations will be done according to this formula:

An investor is considering 4 investments, A, B, C, D. The payoff from each investment is a function of the economic climate over the next 2 years. The economy can expand or decline. The following decision tree has been developed for the problem. The investor has estimated the probability of a declining economy at 40% and an expanding economy at 60%.