Incremental All Incremental All Cost AlternativesCost Alternatives©Dr. Bradley C. Paul 2002©Dr. Bradley C. Paul 2002

Note – The concepts shown in these slides are considered to be Note – The concepts shown in these slides are considered to be commonly known amongst those schooled in the practice of Engineering commonly known amongst those schooled in the practice of Engineering Economics and these and similar ideas are published in a variety of Economics and these and similar ideas are published in a variety of forums no one of which was intentionally used by the author in the forums no one of which was intentionally used by the author in the preparation of these slides.preparation of these slides.

Incremental Analysis Problems Incremental Analysis Problems can also take All Cost can also take All Cost Alternatives FormAlternatives Form

Example - Power companies have to meet peak demands on the system. Someof these peaks seldom happen. In the past under regulation utilities werecharged to give reliable service and allowed to pass the cost of that serviceonto their customers. Utilities built power plants to always stay ahead ofdemand.

Under deregulation utilities are not guaranteed that they can pass costs ontocustomers so the utility industry stopped building. Over the past 4 years wehave had major problems most of the summers with peak demands that aretoo high to meet (ok California has problems during the winter too). In thesecases the price of peak power goes to crazy prices. A kilowatt hour of electricitythat sells for about 9 cents may cost $7.00. All of California’s major utilitieswent bankrupt because they had to pay high prices that they could not pass on.A lot of power trading companies have also gone broke.

Incremental Analysis in Incremental Analysis in All Cost AlternativesAll Cost AlternativesTo guard against wild prices for peak power some utilities have built peakingpower plants just so they won’t have to go buying power when the market istight.

Mnt. Butterscotch is considering building a cover your ____ (CYA) powerplant to handle extreme peak conditions. If they do not build the plant, theywill have to buy power at the market price (even though they can’t sell it forthat). Mnt. Butterscotch analysis have concluded the following.

Cost for Peaking PowerCost for Peaking PowerPrice and Frequency of Need for

Peaking Power

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

75 100 100 100 100

Increment of peaking power

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

Price per KilowattHour

Capacity Factor

Last 175 Megawatts ofCapacity is going to beReal Pricey to Buy

Cost if Mnt Butterscotch Cost if Mnt Butterscotch builds 175 Meg CYA Power builds 175 Meg CYA Power PlantPlant

……………………..

0 1 2 3 4 5 19 20 21

$4,375,000 peryear to build

$3,380,000 per year to retire debt and run plant

Cost if Mnt Butterscotch Cost if Mnt Butterscotch does nothing and buys its does nothing and buys its peaking powerpeaking power

0 1 2 3 4 5 18 19 20 21

…………………...

$53,217,000 per year in emergency power purchases

I think building the CYA I think building the CYA Power Plant Makes More Power Plant Makes More SenseSense

………………….

0 1 2 3 4 5 19 20 21

$4,375,000 peryear to build

$3,380,000 per year to retire debt and run plant

Minus0 1 2 3 4 5 18 19 20 21

…………………...What Kind of Problem am I setting Up?

Cost ofBuilding175 MegPlant

Cost ofBuying last175 Meg ofPowerNeeded

Resulting Cash FlowResulting Cash Flow

0 1 2 3 5 6 7 18 19 20 21

$4,375,000

…………...

$49,837,000 each year

Why do I not think this one will be hard to figure

NPV = $363,973,412 at 12% real rate

Cost andSavings fromHaving 175Meg PlantInstead ofBuying peakPower fromOthers

Now the Incremental Now the Incremental Analysis Version of All Analysis Version of All Cost AlternativesCost Alternatives

Candy Sprinkles suggests that the gas peaking plant should be built to275 megawatts of capacity rather than just 175 megawatts. If the largerpower plant is built, the cost of running it will be as below.

……………………..

0 1 2 3 4 5 19 20 21

$6,875,000 peryear to build

$5,940,000 per year to retire debt and run plant

Cost of Building and Operating a 275 MegPeaking Power Plant

If No Plant is builtIf No Plant is built

The result of building no plant at all is as below.

0 1 2 3 4 5 18 19 20 21

…………………...

$62,090,000 each year

The value of building a The value of building a 275 megawatt plant over 275 megawatt plant over nothingnothing

Minus

……………………..

0 1 2 3 4 5 19 20 21

$6,875,000 peryear to build

$5,940,000 per year to retire debt and run plant

Cost of 275 Meg Plant

0 1 2 3 4 5 18 19 20 21

…………………...

$62,090,000

Cost of Buying last275 MegOf Power

Worth of Building the 275 Worth of Building the 275 Meg Peaking PlantMeg Peaking Plant

0 1 2 3 5 6 7 18 19 20 21

$6,875,000

…………...

$56,150,000

I bet your waiting for me to do an NPV

Now we compare the benefits Now we compare the benefits of the 275 Meg Plant against of the 275 Meg Plant against the 175 Meg Plantthe 175 Meg Plant

$6,875,000

……..

$56,150,000

The 275 Meg Plantgoes in first.

Minus

$4,375,000

……..

$49,837,000 The 175 Meg Plantgoes in second.

New Arrive at the New Arrive at the Benefits of Building the Benefits of Building the Next Increment of Next Increment of CapacityCapacity

0 1 2 3 5 6 7 18 19 20 21

$2,500,000

…………...

$6,313,000

NPV = $42,422,455 at 12%

Cost andBenefit ofAdding100 MegOf PeakingCapacityTo 175Meg PeakingPlant

Do You Catch The PatternDo You Catch The Pattern

In the All Cost Alternatives Form you In the All Cost Alternatives Form you have several cash flow subtraction stepshave several cash flow subtraction steps Take cost of the base case cash flowTake cost of the base case cash flow Take cost of the do nothing alternativeTake cost of the do nothing alternative Subtract the do nothing alternative from the base case - Get Subtract the do nothing alternative from the base case - Get

Benefits of Base case cash flowBenefits of Base case cash flow Take the expanded case cash flowTake the expanded case cash flow Take cost of do nothing (bigger plant so bigger difference)Take cost of do nothing (bigger plant so bigger difference) Subtract the bigger do nothing alternative from the bigger plant Subtract the bigger do nothing alternative from the bigger plant

- Get Benefits of the Bigger Plant- Get Benefits of the Bigger Plant Now subtract the Benefits of the Base Case from the benefits Now subtract the Benefits of the Base Case from the benefits

of the bigger plants - Get the benefits of building bigger.of the bigger plants - Get the benefits of building bigger.

Lets Try it AgainLets Try it Again

Wally Nuts wants to put his idea on the peaking plant too. Wally says theyshould build a 375 Megawatt Peaking Plant, rather than a 275. Wally offersthis cost to build his plant.

……………………..

0 1 2 3 4 5 19 20 21

$9,375,000 peryear to build

$8,810,000 per year to retire debt and run plant

If 375 Meg Plant is Not If 375 Meg Plant is Not Built (ie no plant at all)Built (ie no plant at all)

0 1 2 3 4 5 18 19 20 21

…………………...

$67,200,000

375 Meg Plant minus No 375 Meg Plant minus No ActionAction

0 1 2 3 5 6 7 18 19 20 21

$9,375,000

…………...

$58,390,000

Subtract Benefit of the Subtract Benefit of the 275 Meg Plant from the 275 Meg Plant from the Benefit of the 375Benefit of the 375

0 1 2 3 5 6 7 18 19 20 21

$2,500,000

…………...

$2,240,000

NPV = 11,999,411 at 12%

Cost and BenefitOf adding 100Megawatts toA 275 MegPeaking PowerPlant

Checking the Next Checking the Next IncrementIncrement

Prunella Raisen suggests building a 475 megawatt peaking plant. Her cash flowis as below.

……………………..

0 1 2 3 4 5 19 20 21

$11,875,000 peryear to build $12,590,000 per year to retire debt and run

plant

The No Action Cash FlowThe No Action Cash Flow

0 1 2 3 4 5 18 19 20 21

…………………...$71,200,000

Your AssignmentYour Assignment

Determine whether the 375 megawatt Determine whether the 375 megawatt peaking power plant should be sized up peaking power plant should be sized up to a 475 megawatt peaking plant like to a 475 megawatt peaking plant like Prunella says. (Be sure to clearly show Prunella says. (Be sure to clearly show your work and explain the steps you went your work and explain the steps you went through to reach your conclusion).through to reach your conclusion).