LabworkEnergyMarkets

Report(EvaluatingFlexibility)

GrenobleINP|Ense3
MScElectricalEngineeringforSmartGridsandBuildings

HannanAfifi
MireiaMartinezRibas
RadhikaChatterjee

Part A (static future 30 min): Under the general context of the exercise.Studentisplacedin
the shoes of project manager who has to choose between 2 proposed projectsAandB.Then
provoke a series of sensibility analysis, in order to find the breakeven points afterwhichthe
managerhastochangehisdecisionmadeearlier.
1. CalculatetheNPV(NetPresentValues)todayforPlanAandPlanB
2. ComparethetwoNPVs,whichonepresentsaneconomicinterest?
3. Find the threshold variable cost of Plan B, after which the decision is flipped. (you
can draw the decision function as a function the variable cost of Plan B, aswellyou
can do the same thing to find the threshold for interest rate fixed cost... it is out of
focusofthisexercise)

Answer:
Table1.DemandforecastandDiscountratefor3years

Year

Demandforecast(M)

0.3

0.6

0.9

Discountrate(%)

In the Plan A, producer is Planning to have production with capacity 0.9 M (forecasted
demand for year 3) since year 1. This means that producer has to invest 900 M$ only in the
year0tobuildfacilitywithproductioncapacityof0.9M.
With variable cost of1280$/MWand Unitsellingpriceof2000$/MW,NPVforPlanAcan
becalculatedbyusingformulabelow
T

N P V = (BT C T )/(1 + r)t

(1)

t=t0

where
BT isnetcashflowduringperiodt
C T isinvestmentcostduringperiodt
risdiscountrateandtistheperiod

Table2belowshowscalculationofNPVofPlanA

Table2.NPVcalculationforPlanA
Components

Year0

Year1

Year2

Year3

NumberofProductionline

ProductionCapacity(M)

0.9

0.9

0.9

Capextotal(M$)

900

Opexperunit($)

1280

1280

1280

Salvage(M$)

Unitsellingprice($)

2000

2000

2000

PV(M$)

900

198.1651 363.6058 500.3748951

NPV(M$)

900

701.835 338.229 162.1457898

For the Plan B, instead of having production capacity of 0.9 M from year 1, producer is
Planning to have production capacity 0.3 M in the year 1andincreaseitby0.3M/year. This
Planallowsproducernottopayallinvestmentcostinfrontanddivideitintheyear0,1and2.
In the Plan B, producer has variable cost of 1500 $/MW and Unit selling price of 2000
$/MW. By using the same formula for Plan A(formula1),NPVof PlanBcanbecalculated.
Table3belowshowscalculationofNPVofPlanB

Table3.NPVcalculationforPlanB
Component

Year0

Year1

Year2

Year3

NumberofProductionline

ProductionCapacity(M)

0.3

0.6

0.9

Capextotal(M$)

300

300

300

Opexperunit($)

1500

1500

1500

Salvage(M$)

300

Unitsellingprice($)

2000

2000

2000

PV(M$)

300

137.615 0

NPV(M$)

300

437.615 437.615 1
41.5229311

579.13761

From theNPVcalculationofPlanandPlanB,wecanseethatNPVof PlanA(

162.1457898
M$
)
is higher
than NPV of Plan B (1
41.5229311
M$
)
. This means that Plan A is
economicallymoreinterestingthanPlanB.


Figure1.DecisionfunctionofPlanB

However, by reducing variable cost of Plan B, Plan B can also be more beneficial thanPlan
A. From figure 1, we canseethatthethresholdofvariablecostofPlanBinordertohavethe
same NPV ofPlanAis1486.02$/MW.Therefore,if producercanreducethevariablecostof
PlanBlowerthan1486.02$/MW,PlanBwillbemoreeconomicallyinterestingthanPlanA.
PartB
Under uncertain future, you areaskedtoanalyzethedifferenceinprofitswithrespecttopart
Awherefutureiswellknowninotherwords,therealvalueandrisksofeachproject.
1) Generate 1000 random futures (demand is the uncertain variable, random values
aroundtheoldfixedvalueswith50%variation)
2) For each scenario: calculate the NPV for both projects as well as the differenceand
thedecisionfunction
3) Calculatethemean,maxandaverageforeachPlan
4) Generatetheprobabilitydistributionusing20intervalsforbothPlansNPV
5) Counttheoccurrenceofeachintervalandplotthehistograms
6) Conclude
Answer
Table 4 shows the characteristics of the1000randomfuturesofPlanAandPlanB.Fromthe
maximum,minimumandaveragevalueswehavecreated20intervals.

Table4.ComparisonbetweenPlanAandPlanB

PlanA

PlanB

Maximum

425,264

484,260

Minium

331,483

156,774

Average

96,412

141,231

Lengthofinterval

37,837

32,051


Figure 2 and 3 are the histograms of the probability distribution of NPV values for Plan A
andPlanB.Theintervalsareshown inthe abscisesaxiswhiletheprobabilitytohaveanNPV
in each interval is shown in the yaxis. As an example of interpretation of the graph below,
the first interval shown is from to $331,48 M (included).The probability to haveavalue
in this interval is only 0,01% (1 out of 1000) since it corresponds to the minimum value
($331,48M).Inthesameway,thesecondintervalgoesfrom$331,48Mto$291,365Mand
ithasaprobabilityof0,02%.

Figure2.ProbabilitydistributionofNPVofPlanA

Figure3.ProbabilitydistributionofNPVofPlanB

The standard deviation of the probability distribution function of Plan A and B are 146,553
and 131,88, respectively. This is a measure of how spread the values of NPV are, and
therefore how easy is to move away from the highest probable value. In other words, it
represents theriskthattheinvestor willtaketonotreachthehighestNPVvalueachievablein
theproject.Therefore,thehigherthestandarddeviation,thehighertheriskfortheinvestor.


Inordertoconcludebetweenoneoptionortheotherwehavestudiedthreeindicators:highest
probable interval, standard deviation and probability to have a negative NPV. After
comparingthetwohistogramsof bothoptionsitisconcludedthatproceedingwiththe
project
Bisthemostconvenientoption
fortheinvestorinordertooptimizetheoverallprofits
.
In histogram A, the most probable NPV value corresponds to the interval between
$46,89M and $84,73M. In turns, the most probable NPV value of histogram B
appears within the interval between $131,69M and $163,74M. It is clear to see then
that there is a higher probability to get more profits when investing in projectBthan
inprojectA.
Moreover, if we focus on the information of standard deviation, project B also is the
most convenient one since it shows a lower risk of deviating from the mostprobable
NPVvalue.
Finally, project B is also the best option considering the probability of obtaining a
negative NPV value. In project A there is at least a probability of 19.8 % to obtaina
negative NPV (by summing the probability that the NPV value falls in a negative
interval).Incontrast,thissameprobabilityisonlyaround14%inprojectB.

PartC
In this part in Plan B* a new production line is not going to be installed unless the forecast
forthenextyearexceedstheproductioncapacityofthepresentyear.
1) For the 1000 random future scenario already generated do the same probability
distributionforbothPlanAandPlanB*
2) ComparePlanBandPlanB*
3) ComparePlanA,BandB*,andconclude.

Answer
In this part we have made several changes in the initial values of production capacity and
number of production lines. In this scenario, only if the forecasted demand exceeds the last
yearsproductioncapacity,anotherproductionlinewithcapacityof300unitswillbebuilt.

Table4.ComparisonbetweenPlanAandPlanB,andPlanB*

PlanA

PlanB

PlanB*

Maximum

425,264

484,260

469,665

Minium

331,483

156,774

183,276

Average

96,412

141,231

140,446

Lengthofinterval

37,837

32,051

32,647

Figure4.ProbabilitydistributionofNPVofPlanB*

The standard deviation of Plan B* is 127,73. Once we have plotted the histogram of the
probability distributionfunctionoftheNPVvaluesofprojectB*, letsconcludewhichoneof
thethreeoptionswouldbebetterfortheinvestor.

ComparisonofPlanBandPlanB*
In Plan B*, the mostprobableNPVvaluefallsintheintervalbetween$110,55Mand
$143,19 M with a probabilityof11,2%. Instead,aswesawbefore,themostprobable
NPV value of histogram B appears within the interval between $131,69M and
$163,74M with a probability of 9,9%. Taking into account this indicator, there is no
cleardifferencewhichwouldmakechooseonePlanovertheother.
If we focus on the standard deviation standard, 127,73 for Plan B* and 131,88 for
PlanB.Inthiscase,theriskfortheinvestorwouldbelessifhechosesPlanB*.
Finally, lets compare the probability togetanegativeNPVvalue.Aswesawbefore,
this probability would be maximum 15,4 %. In the new modified Plan B*, there is a
maximum probability of 17,4 % to get a negative NPV. Under this indicator, Plan B
seemsmoreadequate.

ComparisonofPlanA,PlanBandPlanB*

Figure5.ProbabilitydistributionofNPVofPlanA
In the Plan A, ascanbe seeninthefigureabove,themostprobableNPVreliesonthe
value between $96,05 M to $133,66 M with probability of 10.4 %.Comparingtothe
most probable NPV of Plan B* (which relies on value between $110,55 M and
$143,19 M with aprobabilityof11,2%)andthemostprobableNPVofPlan B(which
is between $131,69M and $163,74M with a probability of 9,9%), it is quitedifficult
to say which plan which gives more benefitastherangevaluesandprobabilityof the
most probable NPV for all the plans are almost similar. However, as Plan B has the
highestprobabilityofthemostprobableNPV,itcouldbethemostbeneficialone.
Based on standard deviation value, Plan A has standard deviation of143.0633,while
PlanB*hasvalueof 127,73andPlanBis 131,88.Therefore,PlanAhasthelessrisk
asithasthehigheststandarddeviationvalue.
Based on probability of NPV reaching negative value, Plan A hasprobabilityof20,7
%whilePlanBhasvalueof15,4% andPlanBhasvalueof17,4%.Therefore,PlanB
seems most beneficial economically as it has the lowest probability ofNPVreaching
negativevalue.

Therefore, based considerations above, we can see that Plan B is the mostpreferableplanas
it has the highest probability of the most probable NPV and the lowest probability of NPV
reachingnegativevalue.