Question

This question addresses the difference that can sometimes arise between the market value of equity and the book value of equity. As an example, we'll use the Moss Landing power plant in California, which was originally owned by the utility Pacific Gas and Electric (PG&E) but was sold through an auction process in 1998 to an independent power producer, Duke Energy (note: this was a different company than the “Duke Energy" utility company that operates in North Carolina). a) As of 1998, the amount of non-depreciated capital in the Moss Landing power plant was $50 million. The plant would produce 3.2 million megawatt-hours (MWh) each year. The expected sales price for the plant's electricity was $75 per MWh and the cost of producing one MWh of electricity was $70/MWh. Calculate the present value of Moss Landing at the time of its sale (you can ignore taxes and future depreciation for this problem). Assume that the life of the plant from the time of sale was 20 years and the discount rate is 12% per year. b) Your answer from part (a) would be the “book" value of the Moss Landing power plant. Assume for the purposes of this problem that the value of other fixed assets (besides the Moss Landing power plant) for PG&E at the time of the Moss Landing sale was $100 million; current liabilities were $1 million; net working capital was $200,000; and long-term debt was $25 million. What was the book value of PG&E's equity at the time of sale? Don't forget to include the book value of the Moss Landing plant in your calculations. c) When PG&E put the Moss Landing plant up for auction, it was surprised that the winning bid was S120 million higher than expected (i.e., higher than the book value). Based on this information and the information from part (b), what was the market value of PG&E's equity at the time of the Moss Landing sale? d) What do you think happened to PG&E's share price following the sale, and why?

Answer 1

1.Present Value of Moss Landing plant:

Selling Price per MWH = $75

Cost of Production per MWH = $70

Net cash flow per MWH = $5

Net cash flow per year = $5*3.2 million MWH = $16 million

Net present value of the Plant = $16 million * PVAF(12%,20)

= $16 million * 7.47 = $119.52 million

2.Book Value of equity = Book value of Moss landing Plant + Other assets Value + Net working capital - Long term debt

= 119.52 + 100 + 0.2 -25 = $194.72 million

3. When the Plant was put for Auction and the was sold at $ 120 million higher than the book value then the market value of PG&E's equity will raise by $120 million.

4.Following the sale, the PG&E's will have whooping increase in share price due to less debt obligations