Having estimated the value of the operational phase, we are now ready to estimate the value of a wind farm under development. This is done by introducing the event that the wind farm fails during the development phase using the ENPV model. This DCF based technique is, however, not able to handle the market uncertainty and decisions in the development phase – thereby underestimating the value of the project.
4.3.1. Introduction
In chapter 3, two DCF based models were discussed to value a wind farm under development, the ENPV model and DTA. Of these two models we have chosen to apply ENPV, as it is not possible to estimate the discount rate needed in the DTA correctly. The below figure gives illustrates how ENPV values a wind farm under development.
Figure 4.6 Illustration of the Events During the Development Phase
Source: Own construction
As Figure 4.5 indicates, each stage can turn out as either a success or a failure, caused by events in the development phase. If the project succeeds, it moves into the next stage, and ultimately, the wind farm is constructed, with EE receiving the value of the operational wind farm. If it fails, the project has received a denial from the city council or the compensation demands have become too large. A failure thus implies that the value of the project will decrease to zero. The ENPV then
Operational Phase Development Phase
Operational Cash Flow
Primo 2010
Ultimo
2012 Ultimo
2032
Stage 1 Feasibility Studies
and Pre-approval
Stage 2 VVM and Final
Approval
Stage 3 Complaints and
Compensation
Stage 4 Construction
74 weights each possible outcome with the probabilities found in Figure 2.2 in chapter 2, and discounts these values in order to find the present value of the wind farm under development.
4.3.2. The Probabilities of Events
It is important to note that the probabilities represent either success or failure events in the development phase, as it assumed that market developments have no influence. This means that the probabilities reflect the possibility of failing in the development phase due to technical issues or a political rejection of the project. A similar approach is found in Méndez et al. (2009: 3-4).
4.3.2.1. Non-Measurable versus Measurable Probabilities
A distinction between non-measurable and measurable probabilities is important, as it has been stated that the probabilities used in the ENPV model reflect the events in the development stages.
But probabilities such as the entire subsidy system changing or a new generation technology being invented, are not accounted for in the probabilities. This is due to the fact that the probabilities of such events cannot be measured meaningfully. In general, probabilities which cannot be foreseen at the time of the initial investment decision should not be included when performing a valuation (Willigers and Hansen 2008: 524).
4.3.3. The Discount Rate
A great advantage of the ENPV model is that it explicitly separates the development and operational phase. The separation leads to a discussion of which cost of capital to use for discounting in each phase. As argued in section 3.4, if the notion that the probability of an event is uncorrelated to the market is accepted, then the risk-free rate should be used to discount the costs of development. Meanwhile, the cash flows of the operational phase should be discounted at the cost of equity, as these will still be subject to market risk. The idea to let the events be uncorrelated with the market is to avoid the problems of estimating the discount rate, as discussed in DTA.
4.3.4. Calculation of Expected Net Present Value
The ENPV of the wind farm under development is calculated from the probabilities and costs that were estimated in chapter 2, and the value of the operational phase estimated in section 4.2.4. The calculations are shown in Figure 4.7.
75
Figure 4.7 ENPV Calculation
Source: Own construction
All payments for the stages are assumed to occur in the beginning of each stage, whereas the outcome is resolved at the end. As an example, EE would decide to invest 500,000 in a VVM report without knowing if the final approval would be granted until 12 month later. The chance of entering stage 2 leading to an investment of 500,000 is 50%, as there is 50% chance that stage 1 succeeds.
The chance of entering stage 3 (complaints and compensation), leading to an investment of an additional 500,000 is thus 25%, because both of the prior stages have a 50% chance of succeeding.
In the last column of Figure 4.7, the probability weighted PVs of each stage have been found. The four development stages have been discounted with the risk-free rate, whereas the value of the operational phase has been discounted with the cost of equity. The total value of this column is DKK -60,879, which is the expected net present value of the wind farm under development when events are taken into consideration. A negative expected net present value indicates that the project does not yield the return on equity that EE should require for this project, and their money would be better spent elsewhere.
4.3.4.1. Sensitivity Analysis
To understand the result better, we now perform a sensitivity analysis of the ENPV, shown in Figure 4.8 below. Here we test the sensitivity to the probabilities of events, which we introduced with the ENPV. There are two reasons why we test the probabilities. First, they determine whether the wind farm is developed, and therefore have a large influence on the ENPV of the project.
Second, the probabilities have been estimated for an average wind farm, and it is therefore relevant to see what the value would be with other probabilities. The sensitivity analysis has only been performed on stage 1-3, as stage 4 has a 100% probability of succeeding.
Stage Time Prob.
Stage
Probability of
Construction Cash Flow (t) PV (t=0) Probability Weighted PV
Stage 1: Analysis and Pre-approval 0 50% 100% -100,000 -100,000 -100,000
Stage 2: VVM & Final Approval 0.5 50% 50% -500,000 -491,189 -245,594
Stage 3: Complaints and Compensation 1.5 80% 25% -500,000 -474,029 -118,507
Stage 4: Construction 2.5 100% 20% -61,000,000 -55,811,136 -11,162,227
Value of Operational Phase 3 - 20% 70,479,996 57,827,251 11,565,450
ENPV -60,879
76
Figure 4.8 Sensitivity Analysis ENPV
Source: Own construction
As can be seen from the three charts in the figure above, the ENPV generally increases if the success probability increases. This makes logically sense, as a larger probability of success would mean that the probability of constructing the wind farm increases. Furthermore, we can see from the three charts that the ENPV gradually becomes more sensitive to a change in probabilities, as the development phase progresses. With the probabilities of events introduced, we will now estimate the value of the wind farm, including the market uncertainty and decisions.