Suppose MidAmerican Energy is contemplating construction of a gas-fired power plant. The plant is likely to last

Question:

Suppose MidAmerican Energy is contemplating construction of a gas-fired power plant. The plant is likely to last 25 years and to have no salvage value. Depreciation allowances for tax purposes on the investment of $386 million will be calculated using the 20-year MACRS schedule. If the plant could be operated 24 hours a day every day, it would produce each year 6.04 million megawatt-hours (MWh) of electricity. However, a more realistic estimate is that the plant will operate at an average of 60% of this notional capacity. In the first year of operation, the price of electricity is expected to average $66 per MWh, fuel costs are expected to be $38 per MWh, and labor and other costs are forecast to total $45 million. All prices and costs are expected to rise with inflation at 3% a year. The corporate tax rate is 35%. If the cost of capital is 12%, would you recommend that the company go ahead with the project?

Table 9.2
Tax depreciation allowed under MACRS
Year(s)
20-year
0.........
1.................3.75%
2.................7.22%
3.................6.68%
4.................6.18%
5.................5.71%
6.................5.28%
7.................4.89%
8.................4.52%
9.................4.46%
10................4.46%
11................4.46%
12................4.46%
13................4.46%
14................4.46%
15................4.46%
16................4.46%
17-20...........4.46%
21................2.23%

Salvage Value
Salvage value is the estimated book value of an asset after depreciation is complete, based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important...