Chapter 1

Introduction

A fossil fuel power station is a power station which burns fossil fuel such as coal, natural gas, or
petroleum to produce electricity. Central station fossil fuel power plants are designed on a large
scale for continuous operation. In many countries, such plants provide most of the electrical
energy used. Fossil fuel power stations have machinery to convert the heat energy of combustion
into mechanical energy, which then operates an electrical generator. The prime mover may be a
steam turbine, a gas turbine or, in small plants, a reciprocating internal combustion engine. All
plants use the energy extracted from expanding gas, either steam or combustion gases.

Coal is the most abundant fossil fuel on the planet, and widely used as the source of energy in
thermal power stations. It is a relatively cheap fuel, with some of the largest deposits in regions
that are stable politically, such as China, India and the United States.

Westmoreland Energy, Inc. (WEI), based in Charlottesville, Virginia, was a subsidiary of

Westmoreland Coal Company (WCX). WCX was established in 1854 and held substantial coal
reserves and mining operations in the western United States and Montana. In recent years, WCX
had to contend with the oversupply and low price of Central Appalachian coal.

WEI was formed in 1986 to compete in the independent power and cogeneration market. Its
project portfolio consisted of eight domestic projects with a gross capacity of 850 megawatts of
electricity. Over the past few years, the scope of the power industry had expanded from a
predominantly domestic business to one dealing with diverse international projects. WEI decided
to focus on potential investments in China, Italy and Mexico. WEI approached each market
differently. In Mexico, WEI proposed innovative energy supply partnership for an industrial
complex and was exploring the acquisition of existing private cogeneration facilities. In Italy,
WEI set out to work on a greenfield development. Many of the international projects pursued by
WEI were coal-fired electric-power generating plants, which complemented the firm’s expertise
in coal in independent power generation and mining.

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Basically the report objective is to solve the case for WEI. The case in about forecasting whether
to set up or not an electric power generating plant at Zhangze, China as a key potential investor
had backed away from the deal and decision-making on the part of the Chinese was agonizingly
slow. But in general, setting up a project in China means not only to move WEI into an attractive
power market, but to capitalize on WCX’s historical strength in coal mining in a potentially
high-growth coal production market.

Objective of the report:

The major objectives of the case study are mentioned below:

 Explore the problems to evaluate electric-power-generation project at China with different
economic and political characteristics.
 Summary of different types to risk.
 Evaluate the approach to capital budgeting.
 To know how to take capital investment decisions.

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 Chapter 2
Analysis of the Economy

The People’s Republic of China is situated in eastern Asia, with coastlines on the Yellow Sea
and the East and South China seas.

As contradictory political, economic, and social trends pulled China, a country of nearly 1.2
billion people, in opposite directions in 1994, it was difficult to discern a coherent pattern in the
government’s policies. At the beginning of the year, China’s leaders proclaimed a period of
comprehensive reforms, but these were nowhere in evidence at year’s end apart from the
introduction of a new tax system. Two conflicting images of China were unmistakable. The first
was that of a rapidly developing economic powerhouse, playing an increasingly important
international role and vigorously asserting its interests on the stage of Asian and world politics.
The second was that of a country with decreasing internal cohesion, beset by intractable social
and economic problems and indifferently governed by Communist Party veterans mainly
interested in clinging to power. Ample evidence supported both of these images. China seemed
to be a vessel adrift at high speed, its destination unknowable.

CPC leaders, however, had reason to believe that their political sins would be overlooked by the
outside world as long as the Chinese economy continued to grow and foreigners were given a
piece of the action. In March, Li, fearing inflation and budgetary overruns, forecast a 9% gross
domestic product (GDP) growth rate in 1994, down considerably from 1993’s torrid 13.5%. This
target proved too modest, however, because less than half of China’s GDP was being produced
by the state sector, and 9% growth was considered sluggish by booming coastal provinces such
as Guangdong (Kuang-tung). In fact, the economy continued to expand at an 11.8% clip.

The most worrisome effect of high growth was an upwardly spiraling inflation rate. The
consumer price index shot up 27.4% in the first three quarters of the year, with food responsible
for about half the increase. (The average Chinese spent 50% of personal income on food.) Grain
prices soared owing to sharp increases in the amount the state paid farmers for their grain, as

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well as disastrous floods, the imposition of a 17% value-added tax on goods, loose credit
policies, the effects of price reforms in 1993, and excessive demand. Overall, increases in per
capita income outpaced inflation, but the income gap between the urban nouveaux riches and the
mass of ordinary workers and farmers continued to widen, with disturbing social consequences.

In the first half of 1994, crime soared 20% as new waves of rural migrants contributed to an
accelerating breakdown of social order in the cities. Authorities cracked down on illegal firearms
possession and struggled to control the activities of rapidly proliferating criminal gangs, many
with international connections. In September the deadly rampage of a lone gunman in downtown
Beijing (Peking) was a powerful symbol of growing lawlessness. Among the measures the
authorities used to combat crime was the profligate application of the death penalty, making
China responsible for more than 60% of the world’s state-ordered executions. Officials estimated
that there were 140 million "surplus laborers" in China--more than the entire population of
Japan--a figure that could rise substantially as the shutdown of unprofitable state enterprises
produced massive unemployment. During the first half of the year, 43% of state-run industries
lost money. Any slowdown in urban and national infrastructure construction would further
exacerbate a problem for which there appeared to be no solution other than long-term population
control. The State Planning Commission and the Ministry of Foreign Trade and Economic
Cooperation released a list of 210 major capital construction projects for the period 1993-2000.
Concentrated in the fields of energy, transportation, and agriculture, they were intended to act as
a magnet for foreign capital and facilitate the transformation of China into a modern industrial
power.

The State Council announced a pilot program to provide one-time cash payments to workers who
lost their jobs as a result of plant closings, but the absence of a comprehensive state system of
social security, including unemployment insurance, caused government leaders to shy away from
radical solutions to the problem. Yet pressure from insolvent enterprises for additional
government subsidies made it difficult, if not impossible, to maintain the tight-credit policy
needed to control inflation. The money supply grew by 37% in the first three quarters, rather than
the planned 25% increase. China’s foreign trade approached $234 billion in 1994, with exports
up 30% to $120 billion and imports up 10% to $114 billion. The projected $6 billion surplus

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reversed the previous year’s deficit. China’s foreign-exchange reserves, bolstered by $22.7
billion from foreign direct investment in the first three quarters of the year, increased to $43.7
billion, more than double the level of a year earlier. Beijing’s efforts to reenter the General
Agreement on Tariffs and Trade (GATT) and become a founding member of the World Trade
Organization (which was to replace GATT on Jan. 1, 1995) were blocked by the U.S. and
European countries because of China’s reluctance to fully open its domestic market to
international competition. The U.S., irritated by China’s slow crackdown on the rampant piracy
of U.S. computer software and compact discs, temporarily suspended trade talks in December.
At the beginning of the year, China abolished its dual currency system by withdrawing Foreign
Exchange Certificates from circulation and moving toward a freely convertible Yuan.

China was the largest borrower from the World Bank in 1994, with over $3 billion in loans.
These included $925 million in soft loans from the International Development Association. In
Hubei (Hu-pei) province ground was broken on Li’s controversial pet project, the gargantuan
Three Gorges Dam, scheduled for completion in the year 2009 at an official cost of $11.2 billion.
It was designed to generate 84 billion kw/hrs of electricity annually and to control flooding.
China also unveiled plans for a huge North-South Water Diversion Project, which included a
shift of water from the upper Chang Jiang (Yangtze River) to China’s arid northwestern
provinces. The World Bank and other international lenders shied away from such mammoth
projects, however, because of doubts about their feasibility, efficacy, and human costs. Despite
prevailing optimism about China’s economic future, the difficulties many foreign companies
faced in collecting hundreds of millions of dollars in loans that had been guaranteed by the
government raised significant questions in the international business community about China’s
creditworthiness.

In general at the past, the PRC government had implemented policies to restrain economic
growth rates, control inflation, and otherwise regulate economic expansion. The recent market-
based reforms had made a significant positive impact, but the reforms had been carried out on an
incremental, piecemeal basis. There was no assurance that the reforms would continue or
continue to be successful. Furthermore, the reforms and economic expansion had been more
effective in some provinces than others.

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Although in the past China had used heavy-handed policies to prevent sustained high-inflation
rates, but there was still a probability for depreciation of the Chinese currency, the Yuan (CNY).

The Chinese government had implemented major changes in the country’s foreign exchange
system. The new system emphasized external liberalization and a transparent system based on
rules and pro-development macroeconomic policies.

The new unified exchange arrangement is a managed float. At the start of each day, the PBC
[People’s Bank of China] announces a reference rate based on the average of the buying and
selling rates against the U.S. dollar at the close of the previous day’s trading. Movement of the
renminbi against the U.S. dollar is limited to 0.3% on either side of the reference rate, with the
PBC intervening in the interbank market through purchases and sales of foreign exchange to
keep the exchange rate within this limit. During the first six months of 1994, the exchange rate
remained stable at about Yuan 8.7 per U.S. dollar and the foreign exchange holdings of the PBC
rose.

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 Chapter 3
Analysis of the Industry

Over the past few years, the scope of the power industry had expanded from a predominantly
domestic business to one dealing with diverse international projects. Projected annual growth in
electricity demand in the United States through the year 2000 was less than 2%, with returns on
investment in the range of (8%-12%) per annum. In contrast, international markets were
conservatively expected to grow between (5%-10%) annually during the same period, with
potential returns in excess of 20%. WEI decided to focus on potential investments in China,
Italy, and Mexico. Many of the international projects pursued by WEI were coal-fired electric-
power generating plants, which complemented the firm’s expertise in coal in independent power
generation and mining. In past, China’s legal procedure was not well supported of foreign
investment, but things have changed now. Government already started to reforms its legal
procedure by targeting power sector and proposed “Electricity Law” to support foreign
investment. Government takes necessary steps to control its inflationary economy and
implemented major changes in the country’s foreign exchange system. The new system
emphasized external liberalization and a transparent system based on rules and pro-development
macroeconomic policies.

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Porter’s Five Factors Analysis:

The result of industry analysis by using Porter's Five Factors Model is given below:

Threat of New Entrants:

There are some barriers to entry in the power project industry in China. Extremely large startup
costs, unstable political circumstances, risk of nationalization and high inflation rate are some of
them. Power market now in starting situation and currently there is little threat of new entrants.
But this is may be only for short period. Because, Industry case suggests that within the next few
years, there could be more private & international companies to dominate power project sector of
China for meeting increasing demand of electricity. Threat of new entrants can be more acute by
the attractiveness of mega project which will be built by non-Chinese parties and recent positive
steps taken by the government for example- new proposed electricity law, unified exchange
arrangement, certain sales of electricity etc.

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Bargaining Power of Buyers:
This is the area where WEI or WCX have to think much and takes decision very carefully. From
the case we found that all the power generated by the project would be purchased by the Shanxi
Provincial Electric Power Company rather than being sold directly to other provinces or different
buyer. Hampton also assumed that price of electricity should be indexed to inflation, but Chinese
are not interested about it rather than they include escalation clause which is currently set at 4%
per annum and it is expected that it will be low for political reason. So, Hampton, WEI and
WCX has to consider the sales contract through expert analysis whether it is viable or not in the
inflationary economy like China.

Bargaining Power of the Suppliers:

Main supplier for the Zhangze project is the Shanxi authority. raw material for producing
electricity of Zhangze project is the coal, which will be supplied from the southeastern district of
Shanxi to maximize the advantage of rich coal resources on that area. So, Shanxi will be the key
supplier or only the one supplier for generating the electricity of Zhangze project which will be
established by the WEI. Availability of the coal will not be a problem for the project because
where the project will be established, the area is enough rich by the natural coal. But Hampton,
WEI and WCX has to be sure that the Shanxi province will supply that coal in a reasonable price
throughout the lifetime of the project. And to make sure of that, contract has to be made between
the parties and WEI can reduce the uncertainty and risk through the contract.

Threat from Substitute Products:

We found in the case that there is no other alternative or substitutes for electricity in China, and
they set their target to produce 300000 megawatt from 183000 within a very short time to match
with their growth. Electricity will play the main role for achieving the targeted growth set by the
government. In Zhangze project only coal will be used to generate the electricity which will be
provided by Shanxi province. Shanxi has the advantage of rich coal resources in that area and
WEI needed to maximize the advantage because the project will be established in near rich coal
resources. So, in that case alternative power will not be a much concern for WEI and they don’t
have too much think the availability of resources of coal. So, as a result they don’t have to give
great concern of that issue.

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Rivalry among Existing Firms:
China government just starting the process to build new & big projects for producing electricity
For ensuring development of different provinces & meet their overall desired growth. The
Zhangze project could be a great opportunity for WEI that needed to capitalize on potentially
huge market opportunity in China. The policy taken by the government is now only in starting
phase, and currently we found in the case that no other company is not in the market, expected in
future there will be some other private or non-Chinese party will came for at least 100-200 mega
projects, in that circumstances no rivalry in current situation and in near future there will be less
rivalry among the firm because of availability of the mega project & experienced firm in this
area like WEI should be clearly ahead from the other companies.

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PESTEL Analysis:

PESTEL analysis stands for

 Political factor
 Economical factor
 Social factor
 Technological factor
 Environmental factor and
 Legal factor
It describes a framework of macro-environmental factors used in the environmental scanning
component of strategic management. Here we will use PESTEL Analysis to describe macro
environmental factors of China.

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Political:
These factors determine the extent to which a government may influence the economy or a
certain industry. In the political arena, there are some issues which should be considering in
analysis part. Unpredictable changes between China’s top political leadership could dramatically
change the attitude toward foreign investment. Also China’s communist ideology often left
diplomatic relations with other nations under a cloud of uncertainty. As a consequence of future
radical change in Chinese government there is a possibility that government may nationalize or
expropriate foreign-investment-backed projects. There are also some several positive aspects to
China’s political environment that balanced the apparent risks. China’s central leadership
recognized the need to reform its central planning mentality and to foster a more market-based
approach. In 1992, senior leader Deng Xiaoping called for the establishment of a “socialist
market economy.” China also recognized the need for foreign capital investment to meet its
goals. To that end, it was developing mechanisms such as open economic zones to encourage
foreign capital and technology investment. Finally, local governments had become more
autonomous and had been given more authority to act on their own behalf. Officials in the
Shanxi Province reflected this growing independence and were anxious to close deals to help the
province grow and improve the lives of its people. On a practical level, this meant developing the
province’s infrastructure, such as electricity generation capacity, to support growth.

Economical:
This factor takes into consideration all events that affect the economic environment. Economic
environment of China is one of the most critical areas to evaluate. In the past, china tried to
restrain economic growth rates, control inflation, and otherwise regulate economic expansion by
implementing several policies. Significant positive impact on macroeconomic factors show the
result of the policies taken by the government, but there was no certainty that the reforms would
continue or continue to be successful. Also reforms had been carried out on an incremental,
piecemeal basis and it had been more effective in some provinces than others. There is another
most important issue and may be the difficult one to consideration was the foreign exchange
aspect of the project. Hampton was still concerned with the potential for depreciation of the
Chinese currency the Yuan, though they take heavy hand used policies to control and sustained
the inflation rates in the economy. The Chinese government had implemented major changes in

Page 12
their foreign exchange system. Basically the new system emphasized external liberalization and
a transparent system based on rules and pro-development macroeconomic policies. The new
unified exchange arrangement is a managed float. At the start of each day, the PBC [People’s
Bank of China] announces a reference rate based on the average of the buying and selling rates
against the U.S. dollar at the close of the previous day’s trading. Movement of the renminbi
against the U.S. dollar is limited to 0.3% on either side of the reference rate, with the PBC
intervening in the interbank market through purchases and sales of foreign exchange to keep the
exchange rate within this limit. During the first six months of 1994, the exchange rate remained
stable at about CNY 8.7 per U.S. dollar and the foreign exchange holdings of the PBC rose.

Social:
The project will contribute to the socio-economic development not only to Shanxi provinces also
as well as China. If the Zhangze Power project was taken then it will ensure the use of the coal of
the China, reduce the shortage of power in Chinese countryside. Also if was established near the
coal mine then it would have lessen the burden on the railroads and other transport infrastructure
by reducing the need to transport coal. The expected increase in employment and income for the
regions will help to increase gross income and lead to sustainable development in the economy.

Technological:
These factors pertain to innovations in technology that may affect the operations of the industry
and the market favorably or unfavorably. This refers to automation, research and development
and the amount of technological awareness that a market possesses. Despite the political and
economic uncertainty in China, the situation in the power industry seemed to offer great
potential. From the 1992s onward, the Chinese government actively sought to promote private
and foreign investment in the country by implementing several policies. Because of these
policies, China seems to now a better investment zone than previous to the investor. Specifically
China gave more focus to producing big project for power within a short time to match their
targeted growth. Because they know if they want to achieve their growth rate target, they need
more power. Currently they have 183,000 MW installed capacity, wants to increase their
capacity up to 300,000 within 2000 to match with their GDP target 8% to 9% through the 1990s.
Electricity demand and GDP growth occur at essentially the same rate. If they achieve their

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target, growth in capacity matched GDP growth, but still only reduced the existing power
shortages from 10% to 5% of the total demand. WEI has the technical advantage in China
compared to US, reason behind this is that WCX had actively marketed the concept of mine-
mouth power projects in the United States, but with minimal success due to the abundance of
natural gas. But in China natural gas was not an alternative fuel. Coal was the fuel of choice, and
it was estimated that its production would quadruple over the next decade in China. For
achieving the target WEI already had the essential development expertise in-house or under
retainer through consulting agreements.

Environmental:
The Chinese government has support the coal based power project and they want to use rich coal
resources in Shanxi provinces using it in Zhangze project. In some countries may be coal based
power project is not very supportive, but in case of Zhangze project we find this is not the case in
China. That coal based power project was very welcomed by the government would assist the
project in gaining necessary approvals and funding. We already found through case analysis that
by producing electricity, China can achieve the growth rate by using coal resources. There is no
alternative to achieve the growth rate. So, we assume that coal based project will not be a great
problem for WEI under environmental factor analysis.

Legal:
Significantly enhancing China’s attractiveness as a location for foreign and private investment
which went into effect in 1992 by the more market based approach and central planning
mentality taken by the government of China. But definitely till now legal and regulatory
concerns were closely related to the political situation of China. And political situation depends
through the mandates from China’s leadership. China’s legal system was civil law system;
precedent decided case has little or no value. Foreign investment was affected due to lack of
well-developed law bodies, new laws and inconsistent interpretation of existing law. Although
legal system was under reform but much of the existing legal and institutional framework was
based on government-owned enterprises and a command-and-control structure which results that
power sector operated without contractual arrangements, instead relying on the mechanisms of
central planning. Context of contractual obligation was very different in China than in more-

Page 14
developed countries. And now Chinese government had initiated a series of dramatic reforms
targeted at the power industry to achieve their growth target. So, definitely it’s a positive impact
not only for WEI or Zhangze project but also for other foreign investment in power sector. China
proposed “Electricity Law” and they promote contractual arrangements through the Ministry of
Electric Power definitely make a positive impact in the legal environment.

Page 15
 Chapter 4
Analysis of the Company

Westmoreland Energy, Inc., based in Charlottesville, Virginia, was a subsidiary of

Westmoreland Coal Company. WEI was formed in 1986 to compete in the independent power
and cogeneration market. The company sought to achieve long-term growth through the
development of energy projects in domestic and international markets. Its project portfolio
consisted of eight domestic projects with a gross capacity of 850 megawatts (MW) of electricity.
The company’s typical equity ownership in each of these projects was 30% to 50%.

Ratio Analysis:
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication
of a firm's financial performance in several key areas. The ratios are categorized Profitability
Ratios, Liquidity Measurement Ratios and Asset-Debt Ratios. We used the financial statements
of WEI’s power project at Zhangze for analyzing the Ratios.

Profitability ratio:

Page 16
Debt Management ratio:

DuPont Analysis:

Page 17
Risk Analysis:

Business Risk:
Business risk is the possibilities a company will have lower than anticipated profits or experience
a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales
volume, per-unit price, input costs, competition, the overall economic climate and government
regulations. A company with a higher business risk should choose a capital structure that has a
lower debt ratio to ensure it can meet its financial obligations at all times.
As per the contract WEI only sales their electricity to Chinese authority and collect their main
raw materials such as coal from the same authority. So, there is a risk that WEI will not get the
standard price for their producing electricity and may be they have to pay more for raw materials
compared to market price. Chinese are conservative about the operating assumptions. They
assume only 6000 hour per annum whereas WEI’s power plant basically operated 90% or more,
7884 hours per annum in US. Though, Hampton and Kost were comfortable with a range of
operating hours per year of 5,500 to 6,500. The upper end of the range (74% utilization) was
within reach if everything went as planned. But there is a chance that input cost will rise if they
have to maintain the assumption of Chinese, because fixed will remain same whether the
production hours differ or not. Still now competition in the market is absent because WEI will be
the first company to establish this kind of project with collaboration of China, and The Zhangze
Project could be the foot in the door that WEI needed to capitalize on potentially huge market
opportunity in China. And we assume that it will also remain lower in the future because of
availability of the big project and the advantage of experienced gained by established this kind of
project in China.
Unpredictable changes in China’s top political leadership could dramatically change the attitude
toward foreign investment. Sometimes foreign investment might be threatened. Legal and
regulatory concerns were closely related to the political environment through the mandates from
China’s leadership. No well-developed body of laws governing foreign investment enterprises
existed. As a result, the administration of laws and regulations by government agencies was
subject to considerable discretion. Much of the existing legal and institutional framework was
based on government-owned enterprises and a command-and-control structure. Specifically,
many aspects of the power sector operated without contractual arrangements, instead relying on

Page 18
the mechanisms of central planning. The final and perhaps most-critical area was China’s
economic environment. In the past, the PRC government had implemented policies to restrain
economic growth rates, control inflation, and otherwise regulate economic expansion. Probably
the most important economic issue and one of the most difficult for Hampton to come to terms
with, was the foreign exchange aspect of the project. Although in the past China had used heavy-
handed policies to prevent sustained high-inflation rates, Hampton was still concerned with the
potential for depreciation of the Chinese currency, the Yuan (CNY).

Financial Risk:
Financial risk is the possibility that shareholders will lose money when they invest in a company
that has debt, if the company's cash flow proves inadequate to meet its financial obligations.
When a company uses debt financing, its creditors are repaid before its shareholders if the
company becomes insolvent. Financial risk also refers to the possibility of a corporation or
government defaulting on its bonds, which would cause those bondholders to lose money.
Financial risk is the general term for many different types of risks related to the finance industry.
These include risks involving financial transactions such us company loans, and its exposure to
loan default. The term is typically used to reflect an investor's uncertainty of collecting returns
and the potential for monetary loss.
Investors can use a number of financial risk ratios to assess an investment's prospects. For
example, the debt-to-capital ratio measures the proportion of debt used, given the total capital
structure of the company. A high proportion of debt indicates a risky investment like WEI debt
equity ratio is 75:25 which express the high risky investment for the WEI. But it is possible to
mitigate the risk by using proper business model and also doing appropriate financial analysis.
Another ratio is the capital expenditure ratio, divides cash flow from operations by capital
expenditures to see how much money a company will have left to keep the business running after
it services its debt.
Parent company of WEI, WCX already reported a loss of 8.4 million dollar for first 3 months of
operation. So, in that situation WEI may be in a critical position to pay debt interest or principal
repayment. So, proper justification should be made before taking any decision about debt-equity
ratio.

Page 19
WEI’s organization comprised three operating groups. One of the groups is The Finance and
Accounting Group, which obtained all necessary funding for projects and supported the overall
financial needs of the company. A key potential investor had backed away from the deal because
of slow decision making process. So, financing may create a problem for this project.
Additionally, six investment funds (public and private), with a sole focus on Asian infrastructure,
had recently raised more than $3.1 billion.
There was several financial risk comprise includes- high inflation rates, foreign exchange rates,
potential for depreciation of the Chinese currency, the Yuan (CNY). To address and solve this
problem government take some important and major steps. It includes- implemented policies to
restrain economic growth rates, control inflation, and otherwise regulate economic expansion.
Reforms had been carried out on an incremental, piecemeal basis. Use heavy-handed policies to
prevent sustained high-inflation rates and depreciation of the Chinese currency, the Yuan (CNY).
Implement major changes in the country’s foreign exchange system. The new system
emphasized external liberalization and a transparent system based on rules and pro-development
macroeconomic policies.
WEI and Hampton have to think and analyze where they can use the US debt finance or Chinese
debt finance. If they use debt finance through US bond coupon rate is 10%, and if they use CNY
debt finance coupon rate is 11%. Project can be financed through both US & CNY debts, in that
case both accumulated coupon rate should be calculated. Where ever the debt finances come
from some other information should also be considered like inflation rate, exchange rate, growth
rate etc. WEI authority also have to think that they can earn enough money to pay its debt
interest payment, principal repayment and also they can paid dividend to its owner or equity
shareholder for taking risk.

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SWOT Analysis:
SWOT analysis is an organized strategy that assesses those four components of an undertaking
or business wander. It includes indicating the goal of the business wander or extend and
recognizing the inner and outside components that are positive and unfavorable to accomplish
that target. SWOT stands for Strength, Weakness, opportunities and Threats.

Strength:
Strengths describe what an organization excels at and separate it from the competition: things
like a strong brand, loyal customer base, strong balance sheet, unique technology and so on. It’s
the internal capabilities of the firm to compete in the adverse situation and sustain in the
competitive market.
WEI has the following strengths:
 It has both technology and solutions that will provide a lower Cost of raw materials.
 In-house expertise of coal based power production project.
 A unique business model (CAPM) with proactive and customer oriented approach.
 Historic strength record of coal mining power project.
 Knowledge of rich R&D division.
 Strong portfolio to manage this kind of power project in US.
 Assurance of whole production selling.

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Weaknesses:
Weaknesses stop an organization from performing at its optimum level. They are areas where the
business needs to improve to remain competitive: things like higher-than-industry average
turnover, high levels of debt, an inadequate supply chain or lack of capital. It’s also internal
factors which may lead the firm toward hazard in the future. As a dynamic project manager
Hamton has to try to solve the weaknesses.
WEI has also some weaknesses like:
 Lack of experience of operating business outside US.

 Higher debt-equity ratio is a key weaknesses as per analyze for Zhangze project. Because
WCX or WEI’s equity was in between 30% to 50% in US based project. But for China
project its ratio is 75:25. So, this will be the first project for WEI where debt will be
higher that there previous project.

 Decision making process is longer for WEI, in this case after 1 year of discussion it is not
confirmed whether WEI investing in China or not. So, opportunity cost arises through
this long time process.

 Negotiation is one of the factors where we found WEI weaknesses. For example-
several transmission lines are included in the project costs but still those transmission
lines would not belong to the project.

 Incapability of use alternative fuel is a great weakness for WEI. In US WEI has minimal
success due to the abundance of natural gas. Though natural gas was not an alternative
fuel in China.

 Lack of convince the different parties into the deal like investor or lender may create a
problem for WEI, already one key investor had backed away from the deal of Zhangze
project.

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Opportunities:
It refers to favorable external factors that an organization can use to give it a competitive
advantage. Opportunities are external attractive factors that can be a source of the future
performance and profitability of the company.
WEI has some opportunities where it can exploit possibilities like:
 Attractive power market in China which can be exploiting further.
 Huge shortage of power in China country side.
 Demand increasing in different provinces for development.
 Project expansion opportunity & new project requirement.
 Availability of rich coal resources, key raw materials for producing electricity.
 Mineral rich province of Shanxi helps to grow the power project very much.
 Supported by the government and local authority.
 Joint financing opportunity with the collaboration of government.
 It is expected that demand of power will be grown rapidly in next decade in China.

Threats:
It refers to factors that have the potential to harm an organization. Threats are external factors
which can cause trouble in the future which may hamper profitability of the company.
WEI faces the following external threats also.
 Future potential government policies, new laws and regulations which can be adversely
effect on power project.
 The PRC’s legal system is a civil law system based on constitution which may be
unfavorable for the future operation.
 Unpredictable change of top level political leadership can change dramatically
investment situation or opportunity for the foreign investment.
 Possible threat that project become nationalize or government can expropriate foreign-
investment-backed projects.
 High inflation rate can diminishes the positive approach or acceptability of the project.
 Labor and operating practices of the Chinese would depress production and capacity
utilization levels.
 Continuing coal consumption may create unusual situation in future.

Page 23
 Chapter 5
Problem Statement

WEI decided to focus on potential investments in China, Italy, and Mexico. Many of the
international projects pursued by WEI were coal-fired electric-power generating plants, which
complemented the firm’s expertise in coal in independent power generation and mining. WCX
had actively marketed the concept of mine-mouth power projects in the United States, but with
minimal success due to the abundance of natural gas. But natural gas was not an alternative fuel
in China. Coal was the fuel of choice, and it was estimated that its production would quadruple
over the next decade in China. The State Planning Commission issued an approval letter for the
project in early February 1994. WEI subsequently arranged for a site study to be performed by a
U.S. engineering and construction firm. With the assistance of a number of consultants and an
investment bank, a joint venture agreement was signed on March 9, 1994.
Key points in the agreement included:
Equity joint venture: Where the venture will be capitalized at 75/25 (debt/equity). In the base
case, this meant that WEI would put in 40% of the equity capital, and the Chinese would put in
60%.
Ownership interest: 49% WEI; 51% to be divided among the Chinese parties.
Term: Twenty years from start of construction. Build–operate–transfer (BOT), whereby WEI
would build the plant, operates it during the contract period, and at the end of the term WEI
would transfer the asset to the local partner at no additional cost.
The joint venture agreement brought back to the hard reality of the numbers and the task that
arises some problems-.
 What should be the expected capital structure?
 What will be the appropriate sources of capital?
 Whether the new project of WEI is feasible or not?
 Is there any managerial options related to this project that can increase the chance of
acceptance of the project?

Page 24
Alternative courses of Action:

After analyzing and having deep look in the case we come up with some other options and in our
report we will try to analyze the options and their outcomes. After the calculation of NPV, IRR,
MIRR and real option we will finally try to point out the best option. Here are some options that
we will try to compare with-

 WEI will have some alternative debt sources for their new projects; it can be borrowed
from six investment funds (Public or Private), European Bank, US Bank and Chinese
Bank.
 What will be the WACC if the company includes preferred stock and debt?

Page 25
Analysis of each alternative:

Calculation of cost of capital:

WEI needs CNY 4789.90 million for the project. It can collect up to CNY 3653.55 million
through debt source that reduce the equity weight. And given that Company tries to maintain
their capital structured 3:1.For the calculation we assumed that company will collect fund for
equity fraction by issuing preferred stock in the market in which equity amount will be CNY
733.51 million and rest of the from Preferences share. We assumed company has enough
retained earnings (Break point calculation to determine the retained earnings under viable
assumptions are given later) and company has preferred stocks where it declared dividend CNY
10% per share with face value CNY 100 per share however the flotation cost would be 5%.

WACC Calculation according to Exhibit:6 (Debt Ratio is 23.67:76.33)

Component Amount (in millions CNY) Cost of capital Weight Composite
1005.82 0.08855 0.2099 0.018586645
Debt (China)
2647.74 0.0805 0.5527 0.04449235
Debt (US)
1136.34 0.178749 0.2374 0.042435013
Equity (US + China)
4789.9 1 0.105514008
Total
0.105514008
WACC

WACC Calculation when total debt borrowed from US ( Debt ratio 0:1)
Component Amount (in millions CNY) Cost of capital Weight Composite
3653.55 0.0805 0.7626 0.0613893
Debt (US)
1136.34 0.178749 0.2374 0.042435013
Equity (US + China)
4789.89 1 0.103824313
Total
0.103824313
WACC

Page 26
 WACC Calculation when total debt borrowed from China ( Debt ratio 1:0)
Component Amount (in millions CNY) Cost of capital Weight Composite
3653.55 0.08855 0.7626 0.06752823
Debt (China)
1136.34 0.178749 0.2374 0.042435013
Equity (US + China)
4789.89 1 0.109963243
Total
0.109963243
WACC

WACC Calculation when US equity financed by issuing Proffered stock

Component Amount (in millions CNY) Cost of capital Weight Composite
1005.82 0.08855 0.2099 0.018586645
Debt (China)
2647.74 0.0805 0.5527 0.04449235
Debt (US)
402.83 0.105263158 0.0843 0.008873684
Preferred stocks (US)
733.51 0.178749 0.1531 0.027366472
Equity (China)
4789.9 1 0.099319151
Total
0.099319151
WACC

Page 27
Considering all risk associated with the project, we decided to augment 1.5% risk premium with
the WACC. Thus the projected values of this project are given below:

WACC Calculation according to Exhibit: 6 (Debt Ratio is 23.67:76.33); WACC+RP=9.507%

NPV 1989.16 CNY in Millions

IRR 19%
MIRR 16%

WACC Calculation when total debt borrowed from US (Debt ratio 0:1); WACC+RP=9.338%

NPV 2023.99 CNY in Millions

IRR 19%

WACC Calculation when total debt borrowed from China (Debt ratio 1:0); WACC+RP=9.952%
NPV 1902.20 CNY in Millions
IRR 19%

WACC Calculation when US equity financed by issuing Proffered stock; WACC+RP=9.791%

NPV 2119.65 CNY in Millions

IRR 19%

From the above alternatives we can see the cost of capital is lowest when the company will take
loan from the US. And we know that at a lower cost of capital NPV will be higher for the
project.

Page 28
Calculation of break point:

Assuming the following data we have calculated break point of the company and according to
the calculation company doesn’t need to issue new share up to 9891 million find requirement. If
the company wants to raise the additional funds, it has to pay the additional WACC.

Contribution to retained earnings 1426.875 million

(D/P ratio 75%)
Depreciation 4183.5 million
Equity Fraction 0.25
Break Point 9891 million

Page 29
Country Risk Analysis:
Country risk is a collection of risks associated with investing in a foreign country. These risks
include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is
the risk of capital being locked up or frozen by government action. Country risk varies from one
country to the next. Some countries have high enough risk to discourage much foreign
investment.
Country risk assessment is mainly about assessing a country's ability to transfer currency for
foreign payments. This ability is determined by a number of different circumstances which can
be grouped as political, economic and financial factors.
Country risk can reduce the expected return on an investment and must be taken into
consideration whenever investing abroad. Some country risk does not have an effective hedge.
Other risk, such as exchange rate risk, can be protected against with a marginal loss of profit
potential.
Chine is generally considered the benchmark for moderately country risk.

Country risk can be used:

 To monitor countries where the MNC is presently doing business.
 As a screening device to avoid conducting business in countries with excessive risk.
 To improve the analysis used in making long-term investment or financing
decisions.

Major Methods of Country Risk Assessment:

 International Country Risk Guide (ICRG) Method.
 World CAPM or Multifactor Model.
 Segmented/ Integrated.
 Baysian.
 CAPM with Skewness.
 Goldman Integrated Sovereign Yield Spread.
 Goldman Segmented.
 Goldman EHV Hybrid.
 CSFB Volatility ratio.
 CSFB-EHV Ratio.
 Damodaron Method.

We are going to assess and evaluate the country risk by the ICRG (International Country Risk
Guide) Method.

Page 30
International Country Risk Guide Method:

The International Country Risk Guide (ICRG) rating comprises 22 variables in three
subcategories of risk: political, financial, and economic. A separate index is created for each of
the subcategories. The Political Risk index is based on 100 points, Financial Risk on 50 points,
and Economic Risk on 50 points. The total points from the three indices are divided by two to
produce the weights for inclusion in the composite country risk score. The composite scores,
ranging from zero to 100, are then broken into categories from Very Low Risk (80 to 100 points)
to Very High Risk (zero to 49.9 points).

The Political Risk Rating

Political risk is the risk an investment's returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a change in
government, legislative bodies, other foreign policy makers or military control. Political risk is
also known as "geopolitical risk," and becomes more of a factor as the time horizon of an
investment gets longer.

Political risks are notoriously hard to quantify because there are limited sample sizes or case
studies when discussing an individual nation. Some political risks can be insured against through
international agencies or other government bodies. The outcome of a political risk could drag
down investment returns or even go so far as to remove the ability to withdraw capital from an
investment.

The aim of the political risk rating is to provide a means of assessing the political stability of the
countries covered by ICRG on a comparable basis. This is done by assigning risk points to a pre-
set group of factors, termed political risk components. The minimum number of points that can
be assigned to each component is zero, while the maximum number of points depends on the
fixed weight that component is given in the overall political risk assessment. In every case the
lower the risk point total, the higher the risk, and the higher the risk point total the lower the risk.

The Political Risk Components:

The following risk components, weights, and sequence are used to produce the political risk
rating: Overall, a political risk rating of 0.0% to 49.9% indicates a Very High Risk; 50.0% to
59.9% High Risk; 60.0% to 69.9% Moderate Risk; 70.0% to 79.9% Low Risk; and 80.0% or
more Very Low Risk. Once again, however, a poor political risk rating can be compensated for
by a better financial and/or economic risk rating.

The Political Risk Rating includes 12 weighted variables covering both political and social
attributes. Following is the Assessment of total political stability of China considering all the
political components covered by ICRG.

Page 31
 Political Risk
Point Point Obtaine Sum of
Component s Subcomponent s d section
Government Unity 4 3
Legislative Strength 4 3
Government Stability 12
Popular Support 4 3
Total 9
Unemployment 4 3
Socioeconomic Consumer Confidence 4 3
12
Conditions Poverty 4 3
Total 9
Contract
Viability/Expropriation 4 2
Investment Profile 12 Profits Repatriation 4 2
Payment Delays 4 2
Total 6
Civil War/Coup Threat 4 3
Terrorism/Political Violence 4 4
Internal Conflict 12
Civil Disorder 4 3
Total 10
War 4 4

External Conflict 12 Cross-Border Conflict 4 3

Foreign Pressures 4 3
Total 10
Corruption 6 5
Military in Politics 6 6
Religious Tensions 6 5
Law and Order 6 4
Ethnic Tensions 6 5
Democratic
Accountability 6 5
Bureaucracy Quality 4 3
Total 100 77
Total Percentage of 100% 77%
political risk

As the political risk is 77% which is between 70.0% and 79.9%, so China had a low political
risk.

Page 32
The Economic Risk Rating:

Economic risk is the chance that macroeconomic conditions like exchange rates, government
regulation, or political stability will affect an investment, usually one in a foreign country.

Economic risk is one reason international investing carries more risk than domestic investing.
Shareholders and bondholders often bear the economic risk undertaken by international
companies. Economic risk may also add opportunity for investors. Foreign bonds, for example,
allow investors to participate indirectly in the foreign exchange markets and the interest rate
environments of different countries. But the foreign regulatory authorities may impose different
requirements on the types, sizes, timing, credit quality, disclosures, and underwriting of bonds
issued in their countries.
The overall aim of the Economic Risk Rating is to provide a means of assessing a country’s
current economic strengths and weaknesses. In general terms where its strengths outweigh its
weaknesses it will present a low economic risk and where its weaknesses outweigh its strengths
it will present a high economic risk. These strengths and weaknesses are assessed by assigning
risk points to a pre-set group of factors, termed economic risk components. The minimum
number of points that can be assigned to each component is zero, while the maximum number of
points depends on the fixed weight that component is given in the overall economic risk
assessment. In every case the lower the risk point total, the higher the risk, and the higher the risk
point total, the lower the risk.
Overall, an economic risk rating of 0.0 to 24.5 indicates a Very High Risk; 25.0 to 29.9 High
Risk; 30.0 to 34.9 Moderate Risk; 35.0 to 39.9 Low Risk; and 40.0 or more Very Low Risk.
Once again, however, a poor economic risk rating can be compensated for by a better political
and/or financial risk rating.
Following is the Assessment of total economic risk of China considering all the economic
components of covered by ICRG:

Economic Risk
Components Points Obtained
GDP Per Head 5 4
Real GDP Growth 10 10
Annual Inflation Rate 10 6
Budget balance as a % GDP 10 7
Current Account as a % GDP 15 8
Total 50 35

Total Percentage of Economic risk 100% 70%

As the economic risk rating is 35 that mean 70% which is in between 70% to 80%, so that in
case of China has a low economic risk.

Page 33
The Financial Risk Rating

Financial risk is an umbrella term for multiple types of risk associated with financing, including
financial transactions that include company loans in risk of default. Risk is a term often used to
imply downside risk, meaning the uncertainty of a return and the potential for financial loss.
Financial risk is the possibility that shareholders will lose money when they invest in a company
that has debt, if the company's cash flow proves inadequate to meet its financial obligations.
When a company uses debt financing, its creditors are repaid before its shareholders if the
company becomes insolvent. Financial risk also refers to the possibility of a corporation or
government defaulting on its bonds, which would cause those bondholders to lose money.
Risk is all around us and financial risk and its assessment is one of the most crucial elements of
comprehensive financial planning. The overall aim of the Financial Risk Rating is to provide a
means of assessing a country’s ability to pay its way. In essence, this requires a system of
measuring a country’s ability to finance its official, commercial, and trade debt obligations. This
is done by assigning risk points to a pre-set group of factors, termed financial risk components.
The minimum number of points that can be assigned to each component is zero, while the
maximum number of points depends on the fixed weight that component is given in the overall
financial risk assessment. In every case the lower the risk point total, the higher the risk, and the
higher the risk point total the lower the risk.
Overall, an financial risk rating of 0.0% to 49.9% indicates a Very High Risk; 50.0% to 59.9%
High Risk; 60.0% to 69.9% Moderate Risk; 70.0% to 79.9% Low Risk; and 80.0% or more Very
Low Risk.. Once again, however, a poor financial risk rating can be compensated for by a better
political and/or economic risk rating.
Following is the Assessment of total economic risk of China considering all the economic
components of covered by ICRG:

Financial Risk
Components Points Obtained
Foreign debt as a % of GDP 10 4
Foreign debt service as a % of Exports of goods & services 10 5

Current accountability as a % of Exports of goods & services 15 15

Net internal liquidity as Months of import cover 5 0

Exchange rate stability 10 7.5
Total 50 31.5
Total Percentage of Financial risk 100% 63%

The financial risk rating is 31.5 that mean 63%, which indicates China has a moderate financial
risk, because country obtaining score in between 60.00% to 69.9% has a Moderate financial risk
according to ICRG.

Page 34
The Composite Risk Rating

The method of calculating the Composite Political, Financial, and Economic Risk Rating
remains unchanged. The political risk rating contributes 50% of the composite rating, while the
financial and economic risk ratings each contribute 25%.
The following formula is used to calculate the aggregate political, financial and economic risk

CPFER (country X) = 0.5 (PR + FR + ER)

Where,
CPFER = Composite political, financial and economic risk ratings
PR = Total political risk rating
FR = Total financial risk rating
ER = Total economic risk rating

The highest overall rating (theoretically 100) indicates the lowest risk, and the lowest rating
(theoretically zero) indicates the highest risk.

The overall calculation of composite risk rating is below:

CPFER (country X) = 0.5 (77 + 35 + 31) =71.75

Composite Risk
Risk Type Total Point Weight Total weighted score
PR(Political Risk) 77.00 0.50 38.50
ER(Economic Risk) 70.00 0.25 17.50
FR(Financial Risk) 63.00 0.25 15.75
TOTAL 71.75
Composite Risk Rating Table:

Risk Rating Point Risk Premium

Very High Risk 0.00 to 49.9 0.03
High Risk 50.0 to 59.9 0.025
Moderate Risk 60.0 to 69.9 0.02
Low Risk 70.0 to 79.9 0.015
Very Low Risk 80.0 to 89.9 0.01

As the total composite risk score for the country is 71.75 which indicates country risk for China
is Low Risk. Therefore, the risk premium is 1.5% and WACC will be adjusted with 0.015 risk
premium.

We assumed the ratings as no related information is given in the case.

Page 35
Monte Carlo Simulation:
In this case the NPV of Zhangze project is 2119.65 million CNY, IRR is 19%, and MIRR is
16%. What is the probability that NPV will be more than 2119.65 million CNY or what is the
likelihood that NPV will negative or make loss? Because the entire outcome is not certain as they
make some assumption on inputs such-
 Installed plant capacity (MW).
 Variable cost escalation.
 Operating hour/year.
 Electricity sales price escalation.
 Operation and maintenance Cost.
 Operation and maintenance Cost escalation.
 Cost of capital.
 Initial investment.
We can estimate the probability of any outcome by applying the Monte Carlo simulation. Monte
Carlo Simulation has run by assuming 95% confidence level and 10000 trials.
NPV 2119.65 CNY in Millions
IRR 19%
MIRR 16%

Frequency Chart of NPV:

From the chart we 51% certain that project will Make 2119.65 million CNY and 16 % certain
that NPV will be 0.

Page 36
Sensitivity of NPV:

NPV is more sensitive to Operating hours/year of the project and it’s almost 71.3%; their
correlation is positive. If Operating Hour/year decrease NPV will decrease or Vice-Versa. Cost
of capital is negatively correlated with NPV and sensitivity is not very high; its -6.8%. Plant
capacity (16.4%) and Electricity sales price escalation (4.6%) are also positively sensitive to
NPV.

Page 37
Statistic of NPV:

From the statistic we see that the Coefficient of variation is about .3625 that indicates some risk.
So in terms of NPV it’s a moderate risky project. Minimum value could be -611.47 million CNY
and maximum value could be 5737.73 million CNY.

Frequency chart of IRR:

We are almost 50% certain that IRR will 19% with probability of more than 0.04 and 2% certain
IRR will be 0.

Page 38
Sensitivity chart of IRR:

Here IRR is more sensitive to Operating hours/year it’s near to 78.8% and the correlation is
positive that indicates increase of Operating hour/year will increase the IRR and vice-versa.
Plant capacity and Electricity sales price escalation also positively correlate with IRR but have
low impact.

Statistic chart of IRR:

Here the CV is .2459 that indicates moderate risk level. It shows minimum IRR is 2% and
maximum IRR is 38%.

Page 39
Frequency chart of MIRR:

In 40% certainty level MIRR will be 16% with probability of near 0.06. We are 5% certain that
MIRR will be 0. When we increase the MIRR the certainty level tend to be decrease.

Sensitivity chart of MIRR:

Page 40
Operating hours/year shows 77.4% variation of MIRR with positive correlation. Plant capacity
and Electricity sales price escalation also positively correlate with IRR but have low impact.
Others variables are not highly sensitive.

Statistic chart of MIRR:

Mean and median are very close to base MIRR. The standard deviation is only 2% for MIRR.
CV is .1358 which represents lower risk level.

If we combine this scenario we can conclude the project is moderate risky.

Page 41
Real Option (Alternate courses & Actions):

Option is an opportunity to buy and sell under some specific condition. ‘Call option ‘is the right
to buy and ‘put option’ is the right to sell. Real options exist when managers can influence the
risk of a project’s cash flows by taking different actions during the project’s life in response to
changing market conditions.
Option that involves tangible assets and physical actions instead of financial instruments and
cash flows is called real option.
From the case we found that there is a possibility of getting the opportunity to produce more
electricity by increasing operation and maintenance cost. So it could be real options for WEI that
can increase the NPV of the project. Based on the economic, political, financial and others
factors we made some assumptions.

Assumptions:
We assumed that when WEI will take the decision to increase the efficiency, it needs (CNY)
13.14 million as additional investment. The cash inflow is given in the below table (Overall
Cancelation is given in Appendix section of the Report). The benefit can be realized for 7 years
and the real options can be exercised for 5 years. We discount the cash flow at our optimum cost
of capital and calculate the real options with risk free rate.

Expected returns and probabilities are as follows:

(Amount in CNY in millions)

Calculation of cash
flow
Sales price Additional Cash Flows (in Expected Cash
Situation Probability
(CNY/kwh) production (MW) millions) Flows (In million))
Very high 0.31 22.8 0.2 7.068 1.4136
High 0.33 22.8 0.2 7.524 1.5048
Moderate 0.35 22.8 0.2 7.98 1.596
Low 0.37 22.8 0.2 8.436 1.6872
Very Low 0.39 22.8 0.2 8.892 1.7784
Total 1 39.9 7.98

Page 42
 Calculation
of Variance
Initial Cash PV of Rate of Expected Probability*(Rate of
Probability
cost inflows Inflows Return Rate of return return-Expected)^2
7.068 36.05542426 1.743944007 0.2 0.348788801 0.38929161
13.14
7.524 38.38158066 1.920972653 0.2 0.384194531 0.4723374
13.14
7.98 40.70773707 2.098001299 0.2 0.41960026 0.56340601
13.14
8.436 43.03389347 2.275029944 0.2 0.455005989 0.66249744
13.14
8.892 45.36004987 2.45205859 0.2 0.490411718 0.76961169
13.14
1 2.098001299 2.857144149
Total

Solution:
The Black-Scholes model is used to calculate the theoretical price of European put and call
options, ignoring any dividends paid during the option's lifetime. While the original Black-
Scholes model did not take into consideration the effects of dividends paid during the life of the
option, the model can be adapted to account for dividends by determining the ex-dividend date
value of the underlying stock.

Real option Valuation under Black-Scholes option Pricing Model:

Current Asset Value (CNY in millions) S 40.70773707

Exercise (Strike) Price (CNY in millions) X 13.14

Time to Maturity (Years) T 5

Riskless Interest Rate (% p.a.) rf 0.06

Volatility (% p.a.) sd 1.690308892

d1 2.204867453

d2 -1.574778131

Normal distribution of d1 N(d1) 0.986268302

Normal distribution of d2 N(d2) 0.057653833

Value of Real Option 39.58751057

Page 43
So the value of the real option of Zhangze project is 39.58751057 million in CNY.

True NPV= (39.58751057 + 2119.65)

= 2159.24 million (in CNY)

As the amount is positive, the WEI should run the project at the same time the project is
profitable too.

Page 44
 Chapter 6
Recommendation

We try to focus at the very deep of the case and try to extract the problems that may lies in the
decisions, analysis and the projects. We also tried to figure out some other options that may add
more value to the firm than the existing investment decision.

By analyzing this case we have some recommendation for Zhangze power project:

 WEI should follow Debt Equity ratio of 75:25.

 If possible it should finance from US banks or Six investment funds (public and private),
which sole focus on Asian infrastructure & they recently rise more than $3.1 billion. It’s
an opportunity for WEI from which they can be benefited through Elimination of or
limitation on the recourse nature of the financing of a project, Off-balance sheet treatment
of debt financing, Leverage of debt to avoid dilution of existing equity, Avoidance of
restrictive covenants in other debt or equity arrangements that may preclude project
development, Arrangement of attractive debt financing and credit enhancement, available
to the project itself but unavailable to the project sponsor as a direct loan.
 Considering issuing preferred stock in the market for financing equity portion will hugely
increase the project NPV.
 Considering the Country risk, business risk, we assume that WEI should add 1.5% risk
premium with the selected WACC.
 Infect CAPM model which more desired by Hampton will be beneficial for WEI.
 The scenario analyzed by from the case we found that WEI has real options of getting
opportunity of being producer more power project or expansion project which can
increase the total project Value.

As the NPV is positive so WEI should accept the Zhangze project.

Page 45
Appendix:

Net Cash flow estimation:

Cash inflow (In millions)

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Calendar Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Gross output(MW) 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600
Net output (MW) 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2 553.2
Operating hours/year 5500 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000
Net GWh/year 3042.6 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2 3319.2
Sales price (CNY/kwh) 0.328 0.34112 0.354765 0.368955 0.383714 0.399062 0.415025 0.4316256 0.448891 0.466846 0.48552 0.504941 0.525139 0.546144 0.56799 0.5907095 0.614338
Gross revenue (CNY) 997.9728 1132.245504 1177.535 1224.637 1273.622 1324.567 1377.55 1432.6518 1489.958 1549.556 1611.538 1676 1743.04 1812.762 1885.272 1960.6829 2039.11
Sales tax 49.89864 56.6122752 58.87677 61.23184 63.68111 66.22835 68.87749 71.632588 74.49789 77.47781 80.57692 83.8 87.152 90.63808 94.2636 98.034144 101.9555
Net revenue 948.0742 1075.633229 1118.659 1163.405 1209.941 1258.339 1308.672 1361.0192 1415.46 1472.078 1530.961 1592.2 1655.888 1722.123 1791.008 1862.6487 1937.155
Variable costs
Total variable cost 150.65 174.2004 184.6524 195.7316 207.4755 219.924 233.1194 247.1066 261.933 277.649 294.3079 311.9664 330.6844 350.5254 371.557 393.85037 417.4814
Fixed costs
Operation and Maintenance 54.3 59.17 63.9036 69.01589 74.53716 80.50013 86.94014 93.895354 101.407 109.5195 118.2811 127.7436 137.9631 149.0001 160.9201 173.79375 187.6972
Staff 5.9 6.372 6.88176 7.432301 8.026885 8.669036 9.362559 10.111563 10.92049 11.79413 12.73766 13.75667 14.8572 16.04578 17.32944 18.715798 20.21306
Major overhaul 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899 47.899
Total fixed cost 108.099 113.441 118.6844 124.3472 130.463 137.0682 144.2017 151.90592 160.2265 169.2127 178.9178 189.3993 200.7193 212.9449 226.1486 240.40854 255.8093

Operating profit 689.3252 787.9918288 815.3218 843.3261 872.0026 901.3466 931.3512 962.00667 993.3005 1025.217 1057.736 1090.834 1124.484 1158.653 1193.303 1228.3898 1263.864
Debt interst paid 375.4142 352.184409 326.5655 298.3112 267.15 232.7822 194.8771 153.07005 106.9585 56.09851 0 0 0 0 0 0 0
Depriciation 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279
Profit before Tax 34.91096 156.8074198 209.7563 266.0149 325.8526 389.5644 457.4741 529.93662 607.3419 690.1182 778.7358 811.8343 845.4843 879.6531 914.3029 949.38981 984.864
Income Tax 0 0 31.46344 39.90224 48.87789 116.8693 137.2422 158.98098 182.2026 207.0355 233.6207 243.5503 253.6453 263.8959 274.2909 284.81694 295.4592
Profit after Tax (Net profit) 34.91096 156.8074198 178.2929 226.1127 276.9747 272.6951 320.2318 370.95563 425.1394 483.0827 545.1151 568.284 591.839 615.7572 640.012 664.57287 689.4048
Add depriciation (+) 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279 279
Debt Amortization (-) 226.283 249.5127543 275.1317 303.386 334.5472 368.915 406.8201 448.62711 494.7386 545.5987 0 0 0 0 0 0 0
Equity investment -317 -454 -366
Residual cashflow -317 -454 -366 87.628 186.2946656 182.1612 201.7267 221.4275 182.7801 192.4118 201.32852 209.4007 216.4841 824.1151 847.284 870.839 894.7572 919.012 943.57287 968.4048

Debt Repayment Schedule:

Debt Repayment
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Calendar Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Total
USD Debt in CNY Beginning balance 2647.74 2481.60651 2298.86 2097.838142 1876.714 1633.478 1365.919 1071.603 747.856 391.73408 0 0 0 0 0 0 0
Installment 430.9074918 430.907492 430.9075 430.9074918 430.9075 430.9075 430.9075 430.9075 430.9075 430.90749 0 0 0 0 0 0 0
Principle Payment 166.1334918 182.746841 201.0215 221.1236776 243.236 267.5596 294.3156 323.7472 356.1219 391.73408 0 0 0 0 0 0 0 2647.74
Interest Payment 264.774 248.160651 229.886 209.7838142 187.6714 163.3478 136.5919 107.1603 74.7856 39.173408 0 0 0 0 0 0 0
Ending Balance 2481.606508 2298.85967 2097.838 1876.714464 1633.478 1365.919 1071.603 747.856 391.7341 0 0 0 0 0 0 0 0
CNY Debt in CNY Beginning balance 1005.82 945.670529 878.9046 804.7944516 722.5322 631.221 529.8657 417.3612 292.4813 153.86457 0 0 0 0 0 0 0
Installment 170.7896714 170.789671 170.7897 170.7896714 170.7897 170.7897 170.7897 170.7897 170.7897 170.78967 0 0 0 0 0 0 0
Principle Payment 60.1494714 66.7659133 74.11016 82.26228172 91.31113 101.3554 112.5044 124.8799 138.6167 153.86457 0 0 0 0 0 0 0 1005.82
Interest Payment 110.6402 104.023758 96.67951 88.52738968 79.47854 69.43431 58.28522 45.90974 32.17294 16.925103 0 0 0 0 0 0 0
Ending Balance 945.6705286 878.904615 804.7945 722.5321699 631.221 529.8657 417.3612 292.4813 153.8646 0 0 0 0 0 0 0 0

Outputs:

Outputs
NPV $2,119.65

IRR 19%

MIRR 16%

Profitability Index 7.167658941

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Cost of Capital:

WACC Calculation according to Exibit:6 (Debt Ratio is 23.67:76.33)

Component Amount (in millions CNY) Cost of capital Weight Composite
Debt (China) 1005.82 0.08855 0.2099 0.018586645
Debt (US) 2647.74 0.0805 0.5527 0.04449235
Equity (US+China) 1136.34 0.178749 0.2374 0.042435013
Total 4789.9 1 0.105514008
WACC 0.105514008

WACC Calculation when total debt borrowed from US ( Debt ratio 0:1)
Component Amount (in millions CNY) Cost of capital Weight Composite
Debt (US) 3653.55 0.0805 0.7626 0.0613893
Equity (US+China) 1136.34 0.178749 0.2374 0.042435013
Total 4789.89 1 0.103824313
WACC 0.103824313

WACC Calculation when total debt borrowed from China ( Debt ratio 1:0)
Component Amount (in millions CNY) Cost of capital Weight Composite
Debt (China) 3653.55 0.08855 0.7626 0.06752823
Equity (US+China) 1136.34 0.178749 0.2374 0.042435013
Total 4789.89 1 0.109963243
WACC 0.109963243

WACC Calculation when US equity financed by issuing Preffered stock

Component Amount (in millions CNY) Cost of capital Weight Composite
Debt (China) 1005.82 0.08855 0.2099 0.018586645
Debt (US) 2647.74 0.0805 0.5527 0.04449235
Preffered stocks (US) 402.83 0.105263158 0.0843 0.008873684
Equity (China) 733.51 0.178749 0.1531 0.027366472
Total 4789.9 1 0.099319151
WACC 0.099319151

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