Viento Windmills is a utility that charges customers for their wind generated el
ID: 2653814 • Letter: V
Question
Viento Windmills is a utility that charges customers for their wind generated electricity. With their current technology, they earn a total of $35 million each year to pay out to their 3 million shareholders. While their geographic footprint is fixed and we can't expect the climate to get progressively windier over time, they do have an opportunity to invest in technology that will more efficiently extract the wind energy and thus produce more megawatts to sell to customers. A one-time investment one year from now (t = 1) of $19 million for a state of the art lubricant system for the windmills will lead to extra cash flows that stay constant at $10 million per year starting the following year (t = 2) and lasting forever. If Viento plans to make the investment and cost of equity capital (the discount rate for equity) is 8.5%, calculate the increase or decrease in the share price of Viento as a result of this decision. Draw time line to understand what is going on.
Explanation / Answer
Time Line
In other words, there is a cash outflow of 19M in year 1 and cash inflow of 10 M every year after that.
Value of all the cash inflow in year 1 (at t=1) = value of perpetuity = Annual cash inflow/ Discount rate
= 10M/0.085 = 107.65M
Value of all the investment and cash flow today (at t=0) = (-19M+107.65M)/(1+Discount rate) = 88.65M/1.085 = 81.71M
This is the net present value of the project. Company's net asset should by this amount.
Hence increase in share price = 81.71M/outstanding shares = 81.71M/3M = 27.24
Hence share prices should increase by $27.24
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