Case Prompt:

You are advising the CEO of an energy company on a capital investment decision to expand capacity for electricity production. The CEO is considering a $100 million investment to produce 2,000 units of electricity per week. Your task is to provide guidance on whether the investment is advisable.

Exhibit:

- The proposed investment requires $100 million and would result in a production capacity of 2,000 units (megawatts) of electricity per week.

- The company currently uses natural gas-fired generators.

- Variable costs include gas and labor, with gas costs amounting to $40 per unit and labor costs at $10 per unit.

- The market price for electricity is $100 per unit.

Background:

The energy company is considering a capital investment to expand its electricity production capacity. The investment involves a significant amount of capital and aims to meet the increasing demand for electricity. The company currently utilizes natural gas-fired generators as the primary method of electricity generation.

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Analysis:

To assess the viability of the investment, the following factors should be considered:

1. Fixed Costs: Evaluate the fixed costs associated with the investment. In this case, the fixed cost is the $100 million required for the capacity expansion.

2. Variable Costs: Determine the major variable costs involved in electricity generation. The identified variables are natural gas and labor, with gas costs amounting to $40 per unit and labor costs at $10 per unit.

3. Revenue Potential: Assess the revenue potential from the investment. Since electricity is a commodity, the current market price of $100 per unit in the company's market should be considered.

4. Profitability Analysis: Calculate the contribution margin by subtracting the variable costs from the revenue. Assuming full capacity utilization of 2,000 units per week, the revenue would be $200,000 per week, and the variable costs would be $100,000 per week. This results in a weekly profit of $100,000 or $5,200,000 per year.

5. Payback Period: Determine the payback period by dividing the initial investment ($100 million) by the annual profit ($5,200,000). The calculated payback period is approximately 20 years.

6. Investment Evaluation: Compare the payback period of 20 years with the useful life of the new plant, which is around 30 years. Additionally, consider the payback periods of similar investments made by the company in the past and industry benchmarks to assess the appropriateness of this investment.

7. Risk Assessment: Conduct sensitivity analysis to test the assumption of 100% capacity utilization. Consider the potential impact on the financial model if demand is insufficient to justify the new capacity. Evaluate factors such as new home starts, business growth, and trends in electricity-consuming devices.

8. Competitor Analysis: Examine the moves made by competitors, specifically the impact of their new capacity on pricing strategies and market dynamics.

9. Synthesis and Recommendation:

Considering that the payback period falls within the range of similar investments, it is recommended that the CEO proceed with the investment. However, the CEO should take into account the risks associated with demand sensitivity and potential competitor actions. Continuous monitoring of consumption trends, particularly in energy-efficient appliances, is also crucial.