Gerald Morris is a farmer in Southern Nebraska. He inherited his family farm in 2010 and spent the last five years on getting all his vegetable and grain crops certified as organic and building a network of organic farmers in the area. His farm was featured on the local TV station in the summer of 2018. During the interview Gerald expressed his commitment to sustainable organic farming and urged viewers to consider an eco-friendly lifestyle.

Last month Gerald received a letter from a young fast-growing Alternative energy co-op, soliciting interest in long-term leasing of some of the farm land in the area for the construction of a new wind turbine farm. The energy co-op is looking to place three wind turbines on Gerald's land and offers to pay $26,000 a year per turbine.The lease payments will be increased by 4 percent every five years. The co-op will work with any farmer who is willing to make a land commitment for a minimum of 15 years.If Gerald accepts the offer, he will be required to grant access to the three sites for maintenance or emergency work on the equipment. The co-op's offer is valid for only 90 days, as the company plans to install the wind turbine farm during the summer and fall of 2019 and connect it to the power grid on January 1, 2020.

The letter brought Gerald back to his college days when he and his best friend Jonathan Bishop took a class in renewable energy resources. Jonathan is now an engineer at Honeywell and an enthusiastic supporter of all alternative sources of energy. It was time to call the old friend for some advice. But when Gerald and Jonathan met, Jonathan wasn't entirely sold on the lease offer. He suggested that Gerald may be better off if he invested in the three wind turbines himself. So, the two of them started researching the potential benefits of the ownership alternative.

They found out that each of the 1.2-Megawatt turbines that the co-op is planning to install on Gerald's property will cost $1.35 million dollars (including transportation and installation). The manufacturer also offers a life-time full maintenance contract with a 24/7 service availability at a flat-fee of $1,000 a month per unit for the first 10 years. After the first ten years, the maintenance fee will increase by 5 percent annually1.

Jonathan cautioned Gerald that he will have to plan for the cost of disconnecting the wind turbines from the grid and the cost of demolition and site recovery at the end of this project, which generally totals to about 40 to 45 percent of the initial investment.

The wind turbines will generate revenues on a per kilowatt-hour basis. The capacity factor of the turbines is estimated to be between 30 and 40 percent. The current revenue from a generated kilowatt-hour is 6.2 cents. It is adjusted for inflation every 3 years and the historical adjustment rate is 2.5 percent. An existing Federal program provides a subsidy of 2.3 cents per kilowatt-hour to the owners of wind turbines that are 0.8 Megawatts or larger and are connected to the electric grid. Although the program is set to expire at the end of 2019, there is a 70 percent chance that

1 For simplicity of computations, use annual cash flows. Assume all cash flows are applied at the end of the year.

FIN 442 Intermediate Financial Management_Case 2_Fall 2019

the program will be renewed for another 10 years. The renewal decision, however, will not be announced until the end of January 2020.

Gerald also reviewed his crop rotation schedule to estimate any effect of the reassigned farmland on his expected farming revenues. He predicted that for at least the next four years he is likely to experience losses to his farming revenues. He estimated the losses, starting with the first year, at $80,000, $55,000, $30,000 and $8,000, respectively. Gerald believes that by the fifth year he will be able to eliminate any negative effects on his farming revenues through improved crop selection and optimal crop rotation.

The farm's tax rate is 27 percent (federal plus state liabilities). Additional revenues from lease payments or electricity generation will not increase this tax liability rate. The subsidy (if renewed) will be applied to the before-tax earnings. If Gerald chooses to invest in the wind turbines, he will be able to use the 10-year MACRS depreciation schedule for accounting purposes.

A local banker quoted a loan at 8.5 percent APR due to the size of loan and required that the farm is pledged as collateral for the loan. Gerald also owns a sizable investment portfolio that has earned an average annual return of 10 percent over the years.

Gerald visited the Regional Development office to inquire for the required permits for the installation of the wind turbines. The clerk told him that the Alternative energy co-op secured approval for a wind turbine farm over the entire area. A personal approval for his farm will likely be very fast and will come at a negligible cost. Gerald also found out that the owners of two of the neighboring farm already signed lease contracts with the energy co-op.

With the expiration date of the energy co-op's offer fast approaching, Gerald finds it very difficult to choose between the alternatives. While he now believes that installing wind turbines on his farm is a worthy idea, he is still hesitant if he should choose the long-term lease or opt for direct ownership of the turbines.

What is the best criterion that should be applied in analyzing the two alternatives - leasing part of the farm land vs direct investment in the wind turbines? Why? Discuss the quantitative results of your analysis ?