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Did Power Plant Buyers Pay Too Much?

Fortnightly Magazine - November 1 1999

run time at which Edison Mission may expect to achieve a reasonable return on its purchase, Homer City's per megawatt-hour costs were determined assuming 84 percent capacity utilization. We calculated fixed-cost recovery on a megawatt-hour basis using the cost assumptions shown in table 2.

Financial assumptions, shown in table 2, were developed from our experience in project development and acquisitions, and are consistent with a conservative valuation approach. For example, the assumption of a 70/30 debt-to-equity ratio is viable given the capital structure of many recent divestiture and greenfield merchant projects observed during the past six to eight months.[Fn.2] Also, the after-tax ROE (ROE) of 12 percent is a bit lower than the typical developer hurdle rate of about 14 percent. Here, the ROE is used only to determine acquisition revenue requirements on a unit basis (dollar per megawatt-hour) for comparison to market price projections. In reality, a lower ROE could infer a lower discount rate for use in this value calculation, increasing estimates of plant value. Finally, income and property tax assumptions are representative of U.S. and state tax rates.

The initial book value is assumed to be the $1.8 billion purchase price. Annual Debt Service ($133,145,428 per year) is the fixed payment whose present value is equal to the debt portion of the purchase price (70 percent times $1.8 billion = $1.26 billion). Taxes are adjusted each year by the interest portion of the debt service. The annual depreciation expense is assumed to be straight-line with the first and last years at half the usual annual rate of 5 percent. These assumptions are consistent with common accounting conventions.

The $218 million per year in capital-related costs has been levelized. Fixed costs decline over time as debt principal is paid off and interest expenses fall. In reality, these front-end-loaded capital expenditures can be levelized through a sales-leaseback deal or other arrangement. The fixed annual capital cost shown here results in the same present value as the declining costs, assuming a discount rate equal to the after-tax weighted average cost of capital. At an 84 percent capacity factor, Homer City generates 13,863 gigawatt-hours, resulting in a capital recovery cost (including taxes) of $15.73 per megawatt-hour. (See table 2.)

To determine the price at which Edison Mission will receive a conservative 12 percent ROE, the $15.73 per megawatt-hour annual capital cost must be added to Homer City's operating costs. EIA data indicates that Homer City's fixed O&M costs averaged just over $40 million, or $21.25 per kilowatt-year, from 1993 to 1997. Assuming an 84 percent capacity factor, this translates to approximately $2.89 per megawatt-hour.

By adding its variable operating costs to the revenues required for fixed-cost recovery, Homer City will achieve a modest 12 percent after-tax ROE if it receives an average revenue of $30.65 per megawatt-hour and operates at 84 percent capacity. As mentioned, we believe Homer City may achieve a higher capacity factor in a competitive environment. If it achieves a 90 percent capacity factor, Homer City will realize a 12 percent after tax equity return with average revenues of $29.41