Power Up Plc - Free Essay Example

Sample details Pages: 10 Words: 3086 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Case study Did you like this example? Capital Appraisal of Power Generating Alternatives Introduction Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. Don’t waste time! Our writers will create an original "Power Up Plc" essay for you Create order The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case. The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one. Capital Appraisal The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio. According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199). Expected return on equity = Risk-free return + Beta*(Market return – risk-free return) The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return. The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey Myers, 2003, p. 389). WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E) Where Rd = Return on debt T = Taxation rate Re = Return on equity D = Value of debt E = Value of equity D/(D+E) is the gearing ra tio of a company. The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided. Table I – Cost of equity and WACC The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates. The net present value calculations for the three options are based on the following common assumptions: The power plant starts operations at the beginning of the 4th year. The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate. All yearly clean-up costs are also increased by the annual inflation rates to take into account the likely increase in costs over years. The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period. It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself. The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options. The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations. The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is  £1,636 million. The positive net present value of the power plant indicates that the firms value will increase by this amount if the project is run successfully over 25 years as per the projections. The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WAC C is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is  £1,062 million. This is  £574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method. The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is  £1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant. The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34). The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return. The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period m ethod is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n, then the discounted payback period is given by the following formula. . Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n) Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders. Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and f inal value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0. The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang Swales, 1999, p.133). The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77 % which indicates that the cost of capital can increase substantially before the net present value of the project will become 0. The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0. The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return. The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants. The e xternal consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe. The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project. Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate. Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high g earing (Brealey Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates. The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices . Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method. Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the governments policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model. Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option. Conclusion The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods. Personal learning The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study. First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%. Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment. Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not o f nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option. Bibliography and references Brealey, R. A. and Myers, S.C., 2000. Principles of Corporate Finance, 6th edition, Tata McGraw-Hill Publishing Company. Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company. Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice Education, Vol. 9, Issue 2, pp. 132-137. Dolbeck, A., 2008. Valuation of the Oil and Natural Gas Industry. Weekly Corporate Growth Report, Issue 1473, pp. 1-12. Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice Education, Vol. 2, Issue 1, pp. 31-35. Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162. McLaney, E., 2009. Business Finance: Theory and Practice. Pearson Education Limited, 8th edition. Miller, M.H., 1988. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, Vol. 2, No. 4, pp. 99-120. Modigliani, F. and Miller, M., 1963. Corporate Income Taxes and the Cost of Capital: a Correction. American Economic Review, Vol. 53, Issue 3, pp. 433-443. Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.

Power Up Plc - Free Essay Example

Sample details Pages: 10 Words: 3086 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Case study Did you like this example? Capital Appraisal of Power Generating Alternatives Introduction Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. Don’t waste time! Our writers will create an original "Power Up Plc" essay for you Create order The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case. The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one. Capital Appraisal The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio. According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199). Expected return on equity = Risk-free return + Beta*(Market return – risk-free return) The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return. The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey Myers, 2003, p. 389). WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E) Where Rd = Return on debt T = Taxation rate Re = Return on equity D = Value of debt E = Value of equity D/(D+E) is the gearing ra tio of a company. The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided. Table I – Cost of equity and WACC The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates. The net present value calculations for the three options are based on the following common assumptions: The power plant starts operations at the beginning of the 4th year. The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate. All yearly clean-up costs are also increased by the annual inflation rates to take into account the likely increase in costs over years. The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period. It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself. The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options. The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations. The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is  £1,636 million. The positive net present value of the power plant indicates that the firms value will increase by this amount if the project is run successfully over 25 years as per the projections. The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WAC C is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is  £1,062 million. This is  £574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method. The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is  £1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant. The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34). The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return. The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period m ethod is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n, then the discounted payback period is given by the following formula. . Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n) Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders. Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and f inal value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0. The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang Swales, 1999, p.133). The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77 % which indicates that the cost of capital can increase substantially before the net present value of the project will become 0. The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0. The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return. The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants. The e xternal consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe. The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project. Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate. Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high g earing (Brealey Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates. The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices . Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method. Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the governments policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model. Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option. Conclusion The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods. Personal learning The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study. First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%. Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment. Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not o f nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option. Bibliography and references Brealey, R. A. and Myers, S.C., 2000. Principles of Corporate Finance, 6th edition, Tata McGraw-Hill Publishing Company. Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company. Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice Education, Vol. 9, Issue 2, pp. 132-137. Dolbeck, A., 2008. Valuation of the Oil and Natural Gas Industry. Weekly Corporate Growth Report, Issue 1473, pp. 1-12. Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice Education, Vol. 2, Issue 1, pp. 31-35. Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162. McLaney, E., 2009. Business Finance: Theory and Practice. Pearson Education Limited, 8th edition. Miller, M.H., 1988. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, Vol. 2, No. 4, pp. 99-120. Modigliani, F. and Miller, M., 1963. Corporate Income Taxes and the Cost of Capital: a Correction. American Economic Review, Vol. 53, Issue 3, pp. 433-443. Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.

Power Up Plc - Free Essay Example

Sample details Pages: 10 Words: 3086 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Case study Did you like this example? Capital Appraisal of Power Generating Alternatives Introduction Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. Don’t waste time! Our writers will create an original "Power Up Plc" essay for you Create order The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case. The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one. Capital Appraisal The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio. According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199). Expected return on equity = Risk-free return + Beta*(Market return – risk-free return) The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return. The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey Myers, 2003, p. 389). WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E) Where Rd = Return on debt T = Taxation rate Re = Return on equity D = Value of debt E = Value of equity D/(D+E) is the gearing ra tio of a company. The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided. Table I – Cost of equity and WACC The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates. The net present value calculations for the three options are based on the following common assumptions: The power plant starts operations at the beginning of the 4th year. The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate. All yearly clean-up costs are also increased by the annual inflation rates to take into account the likely increase in costs over years. The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period. It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself. The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options. The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations. The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is  £1,636 million. The positive net present value of the power plant indicates that the firms value will increase by this amount if the project is run successfully over 25 years as per the projections. The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WAC C is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is  £1,062 million. This is  £574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method. The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is  £1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant. The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34). The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return. The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period m ethod is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n, then the discounted payback period is given by the following formula. . Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n) Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders. Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and f inal value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0. The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang Swales, 1999, p.133). The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77 % which indicates that the cost of capital can increase substantially before the net present value of the project will become 0. The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0. The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return. The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants. The e xternal consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe. The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project. Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate. Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high g earing (Brealey Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates. The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices . Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method. Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the governments policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model. Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option. Conclusion The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods. Personal learning The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study. First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%. Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment. Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not o f nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option. Bibliography and references Brealey, R. A. and Myers, S.C., 2000. Principles of Corporate Finance, 6th edition, Tata McGraw-Hill Publishing Company. Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company. Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice Education, Vol. 9, Issue 2, pp. 132-137. Dolbeck, A., 2008. Valuation of the Oil and Natural Gas Industry. Weekly Corporate Growth Report, Issue 1473, pp. 1-12. Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice Education, Vol. 2, Issue 1, pp. 31-35. Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162. McLaney, E., 2009. Business Finance: Theory and Practice. Pearson Education Limited, 8th edition. Miller, M.H., 1988. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, Vol. 2, No. 4, pp. 99-120. Modigliani, F. and Miller, M., 1963. Corporate Income Taxes and the Cost of Capital: a Correction. American Economic Review, Vol. 53, Issue 3, pp. 433-443. Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.

The Adventures Of Huckleberry Finn By Mark Twain - 1894 Words

Throughout history, and even into present times, racism appears as an all too common societal concern. From slavery and discrimination to unequal rights, African Americans’ long history of mistreatment led to the desire and craving for freedom. In Mark Twain’s adventure novel, The Adventures of Huckleberry Finn, such motives from pre-emancipation era African American slaves become evident. In the novel, the characters’ attempts to leave the shackled south for the non-restrained north in hopes of freedom become justified. By analyzing and understanding how society feels about African Americans based on the geographical locations of the Southern United States, the Mississippi River, and the Northern United States, the reader comprehends the influential drive behind the desire to escape racism. In The Adventures of Huckleberry Finn, Twain writes about the adventures of an unlikely duo searching for freedom in the north. â€Å"The Northern and Southern states† divided into â€Å"the Free states and Slave states† (Blight 3). A definite line of pro-slavery and non-slavery existed within the United States during that time period, therefore, those under the ideologies of each geographical area often exhibited the same beliefs. The people of the north believed the act of slavery seemed wrong, whereas the people of the south saw no harm in the acts taking place. These social beliefs influenced Mark Twain’s ideas and thoughts about slavery, which often appear in his writing. Since Twain’sShow MoreRelatedThe Adventures of Huckleberry Finn by Mark Twain830 Words   |  3 PagesThe Adventures of Huckleberry Finn by Mark Twain is â€Å"A Great American Novel†, because of its complexity and richness. Twain writes dialogue that brings his characters to life. 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Grapes Of Wrath By Steinbeck Essay Example For Students

Grapes Of Wrath By Steinbeck Essay The Grapes of Wrath by John Steinbeck is considered a classic novel by many inthe literary field. The trials and tribulations of the Joad family and othermigrants is told throughout this novel. In order to gain a perspective into thelives of Oakies, Steinbeck uses themes and language of the troublingtimes of the Great Depression. Some of these aspects are critiqued because oftheir vulgarity and adult nature. In some places, The Grapes of Wrath has beenedited or banned. These challenges undermine Steinbecks attempts to add realityto the novel and are unjustified. In 1939, The Grapes of Wrath was published andcame under fire for its content. Vulgarity and the misrepresentation of apreacher were the main complaints that led to the ban and burning of the novelfrom St. Louis, Missouri libraries in September 1939. Vulgarity may be prevalentin the book, but it has its purpose. Steinbeck used some vulgar terms toaccurately represent the lingo and slang that was used by the people of the1930s . Most of the terms that were considered vulgar may be a bit distasteful,but is nothing that is not heard on the streets today. Extreme profanity is notextraneous in the novel, in fact, it is tame compared to slang terms used today. Casy, the former preacher that was traveling with the Joads, is not be given theconnotation as the most holy man. Casy did not consider himself a minister atthe time The Grapes of Wrath takes place. But I aint a preacher nomore is spoken many times by Casy in denial that he is a man of the cloth. Indeed, Casy is brutally killed in the novel, but it does not go into graphic,violent detail. Once again, Casys feelings against the employers and governmentwere common to the time and were used to state that idea. Another point ofcontroversy lies on The Grapes of Wraths closing sequence. In this finale, anold man nurses from Rose of Sharon, a young women whose baby was deliveredstillborn. Some believe this is pornographic, sexually oriented, and improper,especially for young children. In fact in some states, the sequence is takenout. This sequence may be a vulgar, but it is an essential element to the noveland is in no way pornographic. It shows the desperation of the migrants to doanything to survive, no matter what the implications may entail. Those who aremissing this ending, such as those who read editions in Texas, are missing thisimportant element of The Grapes of Wrath. These readers may never fullyunderstand the lives of migrants in the 1930s . The novel may have some adultc ontent, but it was never meant to be read by young children. The targetaudience, ages over 14, can look beyond the visual picture and fully ascertainthe sections deeper meaning. Others may critique Steinbecks use of socialisticand anti-government messages. During the 1930s, these ideas were very common. In fact, Upton Sinclair, a socialist writer, was nearly elected governor ofCalifornia. Living conditions, the opposition between the Californians and theOakies, and the inability to break out of the depression all addedto beliefs of the times. Steinbeck was not advocating socialism, he was justreflecting the times. Without these individual beliefs of the redsand other people that showed either socialistic or anti-establishment messages,the reader would get a dry, unfulfilled perspective of the lives of peopleduring the Great Depression. Censorship does have its place in society. Thereare many things that are too risquà ©, degrading, and should not be shown. .u2ae2d9210c15a414a7e8713296c801a5 , .u2ae2d9210c15a414a7e8713296c801a5 .postImageUrl , .u2ae2d9210c15a414a7e8713296c801a5 .centered-text-area { min-height: 80px; position: relative; } .u2ae2d9210c15a414a7e8713296c801a5 , .u2ae2d9210c15a414a7e8713296c801a5:hover , .u2ae2d9210c15a414a7e8713296c801a5:visited , .u2ae2d9210c15a414a7e8713296c801a5:active { border:0!important; } .u2ae2d9210c15a414a7e8713296c801a5 .clearfix:after { content: ""; display: table; clear: both; } .u2ae2d9210c15a414a7e8713296c801a5 { display: block; transition: background-color 250ms; webkit-transition: background-color 250ms; width: 100%; opacity: 1; transition: opacity 250ms; webkit-transition: opacity 250ms; background-color: #95A5A6; } .u2ae2d9210c15a414a7e8713296c801a5:active , .u2ae2d9210c15a414a7e8713296c801a5:hover { opacity: 1; transition: opacity 250ms; webkit-transition: opacity 250ms; background-color: #2C3E50; } .u2ae2d9210c15a414a7e8713296c801a5 .centered-text-area { width: 100%; position: relative ; } .u2ae2d9210c15a414a7e8713296c801a5 .ctaText { border-bottom: 0 solid #fff; color: #2980B9; font-size: 16px; font-weight: bold; margin: 0; padding: 0; text-decoration: underline; } .u2ae2d9210c15a414a7e8713296c801a5 .postTitle { color: #FFFFFF; font-size: 16px; font-weight: 600; margin: 0; padding: 0; width: 100%; } .u2ae2d9210c15a414a7e8713296c801a5 .ctaButton { background-color: #7F8C8D!important; color: #2980B9; border: none; border-radius: 3px; box-shadow: none; font-size: 14px; font-weight: bold; line-height: 26px; moz-border-radius: 3px; text-align: center; text-decoration: none; text-shadow: none; width: 80px; min-height: 80px; background: url(https://artscolumbia.org/wp-content/plugins/intelly-related-posts/assets/images/simple-arrow.png)no-repeat; position: absolute; right: 0; top: 0; } .u2ae2d9210c15a414a7e8713296c801a5:hover .ctaButton { background-color: #34495E!important; } .u2ae2d9210c15a414a7e8713296c801a5 .centered-text { display: table; height: 80px; padding-left : 18px; top: 0; } .u2ae2d9210c15a414a7e8713296c801a5 .u2ae2d9210c15a414a7e8713296c801a5-content { display: table-cell; margin: 0; padding: 0; padding-right: 108px; position: relative; vertical-align: middle; width: 100%; } .u2ae2d9210c15a414a7e8713296c801a5:after { content: ""; display: block; clear: both; } READ: The red pony EssayPornography, extreme sexual content, and extreme gratuitous violence does nothave its place in literature or in society. The Grapes of Wrath does not haveany of these above aspects. Of those who choose to ban this book and other worksof literature with questionable themes, many of them are wrapped up in politicalcorrectness. In literature, life should be shown like they it is, not as someonewould like it to be. As much as political correctness advocates would like tochange things for the better, they cannot change the past no matter how hardthey try.