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C3 - South West Windpower

C3 - South West Windpower - ECCH Collection 297-024-1 South...

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Unformatted text preview: ECCH Collection 297-024-1 South West Windpower This case was written by Gerry Mortimer and Don O’Riordan, Dublin Institute of Technology. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was made possible by the co-operation of an organisation which wishes to remain anonymous. © 1997 Gerry Mortimer and Don O’Riordan, Dublin Institute of Technology, Ireland. EA EU PEAN CA RING HOU SE RO SE CL Distributed by The European Case Clearing House, England and USA. North America, phone: +1 781 239 5884, fax: +1 781 239 5885, e-mail: [email protected] Rest of the World, phone: +44 (0)1234 750903, fax: +44 (0)1234 751125, e-mail: [email protected] All rights reserved. Printed in UK and USA. Web Site: http://www.ecch.cranfield.ac.uk. 297-024-1 South West Windpower By Gerry Mortimer and Don O’Riordan Faculty of Business. Dublin Institute of Technology Note: This case should be read in conjunction with the supplied spreadsheet model SWW.XLS which contains detailed financial projections for the enterprise discussed The Immediate Issue “ Here we are, four brothers sitting around Jim’s kitchen table drinking cups of tea. It is hard to believe that we have decisions to make before Friday running into millions” Sean Murphy laughed uneasily. His brother Jim was keen to get to the point quickly ” As I see it there are three clear decisions to be made and we have about three days to make them. 1 Are we going to build an electricity generating wind farm? 2 If so how are we going to finance it. 3 If we go ahead, we will obviously apply to the to Government Department of Energy to be part of the Alternative Energy Requirement Programme. That way we are guaranteed a price for our output. However, we also have to decide what if any grant we are going to apply for under the Programme. The government has set aside £15 million to provide 60 megawatts of electricity from projects like we’re talking about but also including biomass and hydro as well as wind-based ” “ Okay,” said Brian, the youngest brother, “Laptops on the table and lets go through those figures again!.” Origins of the Project The Murphy family had lived for generations on a relatively remote peninsula in south western Ireland. The family had always been an enterprising one. The brothers’ father had operated a small haulage business, while their mother had managed a small post office and grocery store. Jim, the eldest brother, had remained in the area and had trained as an electrician with the state-owned Electricity Board which has an effective monopoly of electricity supply in Ireland. Having worked for 20 years with the Board, Jim had taken early South West Windpower 1 of 8 297-024-1 retirement and had taken over the family business from his parents. He had successfully developed a tourist-related business in an area of great scenic beauty which had experienced an upsurge in tourism though the nineteen eighties. The business now included a pub, caravan park and sports centre. Jim’s younger brothers had also been obliged to move away from the area in search of work. All now were in business on their own account. Sean was a builder in the nearest large town, some 50 miles distant and Brian and Dick jointly owned a haulage business in the north west of England and also had other business interests there. Jim was now in his early fifties and the other brothers in their forties. Although it was ten years since Jim had left the Electricity Board, he still retained an interest in the area of electricity generation and had taken a keen interest in developments in smaller scale generation, particularly those using wind and wave power. Developing the Idea He had read extensively on the subject and was regarded as highly knowledgeable in the area. He had also attended a number of conferences on wind energy throughout Europe. He knew from his contacts that, though wind generated electricity was still considered uneconomic without some form of subsidy and or guaranteed price, the economics had been gradually improving as towers and wind turbines had become more sophisticated. Although intuitively he knew that the peninsula facing the Atlantic Ocean and the prevailing south westerly winds was an ideal site for a wind farm, he had confirmed this with detailed reports from the Irish Meteorological Service. Some years previously he had purchased a site of some 1,000 acres a few miles from his own home and business. The land was poor and he had obtained it for a relatively low price. The land sloped gently upwards from a coastal plain and was, he reckoned, an ideal site for a wind farm. There were however, complications. He would have to obtain planning permission for the use of the site as a wind farm. In addition the local electricity grid was relatively weak and he had been informed by the Electricity Board that he could only supply the rated equivalent of 2.5 megawatts into the grid. This might involve five towers each at a rated output of 0.5 megawatts. The amount of electricity generated a year would depend upon the wind regime. There was a proposal to upgrade the grid but it was likely to be some years before this was done. As a remote non-industrial area the peninsula was not a priority for the Electricity Board. Jim had kept his brothers informed of his plans South West Windpower 2 of 8 297-024-1 for a wind farm and all three had expressed interest in joining him in the project. The brothers all saw the project as potentially generating a pension for each of them. All three brothers not living in the area envisaged returning there when they retired from business. The partners had agreed to develop the project jointly with each taking a 25% stake. Jim would manage the project and his investment would be use of the land. Each of the other were prepared to invest about £60,000 in the project and were prepared to wait a considerable number of years for a return. Testing the Idea The first major phase of the project involved an extended site test. This involved erecting a wind monitor to assess wind frequency and strength over a period of up to 18 months. Data from the monitor would be sent on a regular basis to a specialist group in the UK for analysis. This would be used to assess the projected output of a wind farm at the site. Wind varied over different periods of the day and the time of year. However, it was considered that an 18 month trial was reasonably predictive. The trials pointed towards an output per turbine over the entire year of about 2.6 or 2.7 megawatts but not all of this could be sold as there would be site transmission and other efficiency losses of about 12%. The price the Electricity Board would pay for electricity generated under the scheme that the Murphy brothers were seeking to join, was set at 6.4 pence per kWh for peak time supply and 2.5 pence for off-peak supply. Since the wind farm would have no control over the prevailing winds, the estimated combination of these two rates would have to be based on the 18 month trial. This pointed to an average rate of 4.0 pence per kWh sold to the national grid. This is the equivalent of £40,000 per megawatt supplied. This amount would then increase with inflation each year over a twenty year contract. Some Practicalities of the Project “What would it cost and would we really make any money out of it? “ had been Sean’s initial question when Jim first told him of his idea for the wind farm project three months earlier. “ Oh, I think we would.” Jim had argued “ Actually we could do quite nicely out of the whole South West Windpower 3 of 8 297-024-1 thing. The Electricity Board guarantee to buy everything we produce for the next twenty years and the price rises with inflation. You won’t do much better than that! ” But Brian persisted. “ That’s all very well but what about the cost of all these windmills and cabling and the rest of it. I’m pretty sure that this kind of stuff is expensive.” Jim agreed. “ It is, but the Department of Energy is prepared to pay a grant to make it worthwhile. The only trouble is they won’t say how much the grant will be. They have allocated £15 million but that is to cover lots of such schemes around the country. We will have to tell them how much we would need to make the project viable. In effect its like a kind of tender with the grant - not the price being the variable involved.” “ as far as the investment is concerned, I think we are talking about something like two and a half million pounds. but with a grant of, say, half a million we’re down to two million or less. I reckon that with a bit of leverage and soft finance we could get into it for about a quarter of a million pounds between the four of us.” The deal referred to was one where the state-owned Electricity Board was being encouraged to buy in additional generating capacity from private-sector entrepreneurs using non-nuclear renewable energy resources ( wind or wave or water power etc. ) to replace or supplement fossil fuel electricity generation, where oil, coal or gas is used. Such entrepreneurs were invited to offer to supply electricity at a guaranteed long-term price and uptake in specific localities. To encourage this a European Union-funded non-repayable capital grant was available for such private schemes. The drawback from the brothers’ point of view was that the amount of the available grant was unknown and was, in effect, subject to market forces. If their tender required too high a grant they might not get a contract and if it was too low they might not get an adequate return on their investment and efforts. Equipment and Costs Jim been talking to a Swedish company which specialised in wind turbines. Earlier in the year he had been to an exhibition in Aberdeen where he had collected a lot of technical data on output capacity and capital costs of turbines and towers. The Swedish company, Stromsterk, had extensive experience of installing wind turbines for commercial applications all over the world. The must suitable type of installation for the kind of conditions and aspect of the particular site would be the M6200. This is a three-blade turbine unit mounted on a 15 metre South West Windpower 4 of 8 297-024-1 metal tower and which could produce an electrical output of 2.7 megawatts per year based on the site wind characteristics indicated by the 18 month testing period. Each M6200 turbine would have a capital cost of £500,000 and this includes site installation by Stromsterk and cabling to a supplied control unit which can control up to twenty such turbines. Site preparation and construction of a small building to house the control units would cost between £ 50,000 and £100,000. This pointed to a total capital cost as follows. Site Clearance and Control building 5 turbines @ £500,000 £100,000 £2,500,000 £2,600,000 Finances and Financing of the Project Some while earlier Brian had introduced Jim to Melanie, a freelance financial consultant who had done work for Brian and Dick’s haulage business in Britain. Brian believed her advice would be helpful in providing a more objective view of the overall project and, in particular, she could prepare detailed financial projections both for the brothers’ own use and for talking to banks or other sources of finance. There had been general agreement on this and Melanie had already carried out a considerable amount of background work on the project. She had spoken to Stromsterk and another wind turbine supplier and had, with Jim, spent three days at meetings in Limerick, Dublin and London. They spoke to a major firm of tax accountants, several banks, a number of venture capital intermediaries, and two Irish state agencies. Melanie met with the four brothers to outline how she saw the project: Revenue would be about half a million a year ( based on a gross output of 2.73 megawatts per turbine and with 12% efficiency losses ) and this would rise with inflation. Furthermore, sales and prices would be guaranteed for the entire 20 year life of the project. After that, if the equipment could still produce electricity, further sales were possible but were not guaranteed. On the other hand by that time there might be further de-regulation of the market for electricity and other potential purchasers. But Melanie pointed out to them that though there might be further revenues after 20 years but money receivable that far down the line would South West Windpower 5 of 8 297-024-1 have a fairly low present value when one allowed for the time value of money. It was considered to limit the planning horizon to 20 years and assume that the project finished at that stage The wind farm would have low operating costs. The biggest cost would be the write-off of the capital equipment over its estimated physical life of 20 years in equal instalments. Servicing of the equipment, including contract maintenance by Stromsterk, would be £50,000 annually and other operating costs including local land taxes and a small rent for the site would come to £25,000 a year. Operational support costs would consist of the part-time services of one person to oversee the operation and this would be covered by an annual amount of £20,000 payable to one of Jim’s other companies. These three costs would also be assumed to increase in line with inflation. For planning purposes, credit of one month would be taken on the Services/Maintenance costs and on the operational support costs. In the medium term, payment for electricity uploaded to the national grid would be paid within three weeks of the end of each quarter. Based on the above, Melanie prepared a 20 year spreadsheet model of the financial aspects of the project where all the variable items were isolated so that they could evaluate the effect of nearly any combination of circumstances. The brothers had this spreadsheet model loaded onto their laptop computers when we first met them on page one of the case. Raising the Finance It was generally agreed that if the project went ahead, they would form a private limited company to be called South West Windpower Ltd. Profits from electricity generation would qualify at the lowest rate of company tax of 10%. Ancillary income, such as from bank interest receivable, would, however, be taxed at normal company tax rate - at that time 40%. Ideally they believed that the amount to be invested by the brothers should be equally split but they had no intention of financing all of the £2.6 million themselves. This would not be possible and might not even be desirable. There were several other financing options available however. One possibility that they all liked was that of obtaining equity funds under what is popularly known as the “Business Expansion Scheme”(BES), a tax incentive arrangement to encourage risk investment by giving individual taxpayers tax relief on ordinary share investments in South West Windpower 6 of 8 297-024-1 companies that qualify. It seemed that this company might qualify. The way it would work is as follows. The money would come from private investors ( who could offset it fully against their top marginal income tax rate of 48% ) through a banking or venture capital intermediary which would supply it to the company as a single amount. The company would issue special redeemable ordinary shares on which no dividends would be payable and which then would be redeemed at the start of the sixth year at a premium of 10% of the amount raised. The problem would be that by law the redeemed share capital would have to be replaced by a new share issue at that point or else the amount covered by accumulated profits which would then have to be “locked in” by being set aside and thus no longer available to be paid out in dividends to remaining shareholders. The following were the financing choices now open to the brothers . 1 The brothers could raise some of the money themselves. Such money would have the advantage of being secure and permanent and not require any cash outflow such as would be the case with bank loans. However the amount such money available was limited to about a quarter of a million pounds. It was projected that, if the company could afford it, dividends would be paid from perhaps the third year. A figure of £50,000 per annum was being projected which would give each of them an annual dividend of £12,500 on an initial investment of about £65,000 each. All were in a position to sacrifice this if necessary, though some of the brothers were less enthusiastic than others about such a prospect. 2 The banks seemed to understand about wind farms and the current state of the art in them and were prepared to lend accordingly. At least one bank was prepared to lend up to a maximum of £1.5 million on a term loan basis over seven years. The interest rate would be fixed at 9.25% and the loan would be secured by a charge on the assets. 3 Money under the “Business Expansion Scheme” could be arranged but, this was limited to a maximum of £1.0 million for any one company or group. This money seemed to be fairly readily available. South West Windpower 7 of 8 297-024-1 4 A state grant of unknown amount would be available but the higher the grant sought, the lower the chances of obtaining the contract to supply the Electricity Board. Any such grant would be non-repayable and would be amortised over the 20 year life of the project by writing equal amounts into profits each year. This benefit would not be subject to company taxation, making it even more valuable. A small complication would be the six month delay in actually obtaining the funds giving rise to the need for bridging finance - i.e. a short term overdraft to cover the delay. This should easily be obtainable but would involve interest costs at an estimated 11.0% per annum. The same rate would apply to any casually arising overdrafts. Conversely, cash surpluses arising would attract a deposit rate with the banks of only 4%. The Big Decisions The Murphy Brothers had now to decide how to proceed. Should they go ahead with the project and if so with what mixture of financing? What grant, if any, should they seek? They could pitch for a contract at a low or zero grant and forgo any benefits a grant would give their company or they could go for a high grant strategy and risk not getting the contract at all. Little or nothing could be found out about competing groups so they would remain very much in the dark on the scope for grant levels. All they could do was examine their own costs and find their own area of comfort with the project based on incomplete data. If, for example, other interested parties applied for the full 60 megawatts capacity sought without any grant financing, then no grants need be paid out and those relying on grants would not be awarded a contract. The extent of interest was unknown, thought Jim, in particular, was aware that several UK-based power utilities were interested and many of these had previous experience of wind generated energy South West Windpower 8 of 8 ...
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