To Main Proceedings Document
VALUE AND RISK EVALUATION OF POWER PROJECTS:
A SYSTEM DYNAMICS APPROACH
Marciano Morozowski Filho Fabiola Sena Vieira Silveira
UFSC - Federal University of Santa Catarina - Brazil
+55 41 335 08 36 and +55 48 331 9731
lara.m@netpar.com.br and fabiola@ gpse.ufsc.br
ABSTRACT
This paper describes a computational model denominated SUN (Business Unit Simulator, in
Portuguese), which evaluates financial-economic performance of Strategic Businesses Units
(SBU’s) and/or investment projects under two approaches: deterministic and stochastic. Under
the deterministic approach, each project is associated to a single cash flow, that may be evalu-
ated with both the traditional methodology (Net Present Value and Internal Rate of Return) and
the value based methods (Economic Value Added and Market Value Added). Under the stochas-
tic approach, a set of cash flows is associated to each project, representing postulated scenarios.
Based on these scenarios, the CAPM (Capital Asset Pricing Model) method is used to assign a
risk index (Beta) to each project. The model evaluates the potential impact of a project, either
stand alone or as part of the investment portfolio of a utility, on the SBU profitability. Therefore,
it fills a gap in the available project analysis “toolkit”, under two main aspects: shareholder
value creation and project risk analysis. Given its flexibility, SUN may become an important
component of a decision support system, from project analysis to the evaluation of value and risk
embedded in SBU and firm wide restructuring.
INTRODUCTION
The production and trading activities in the Brazilian electricity market is now based on competi-
tion. This structure will increase the number of agents and the range of business arrangements
amongst the agents, thus increasing the complexity of evaluation and selection of investment pro-
jects in power sector. This added complexity challenges the capability of traditional models used
in the financial-economic planning of electric utilities, that shall now consider a business risk
component.
The hierarchic structure (left side) represents the traditional, regulated system planning point of
view and was built under a technical-economic perspective. This structure is still valid under the
competitive business environment, but requires a complementary hierarchic structure to better
capture the economic-financial perspective of the business planning in the new environment (right
side of the figure).
Interconnected system Electricity Sector
Corporate
Subsystem
Strategic
Business
Unit
Plants Projects
In the business planning structure, a SBU corresponds to a firm’s business activities at an specific
industry segment and may be associated to each possible intersection between a firm and an indus-
try segment and. A SBU is an autonomous operating unit in what regards business management.
The figure below represents a firm with four SBU’s operating in the areas of Generation, Com-
mercialization, Transmission and Distribution.
Generation ity Sector... smission
SBU-G © SBU-T
Corporation...
SBU-C SBU-D
(Commercialization { Distribution
Investment projects are the basic components of the business plan of a SBU and are an underlying
notion to planning hierarchy structure. The project concept, so defined, contrasts with SBU no-
tion, that are continuous operations, at an indeterminate time interval (normally limited by a plan-
ning horizon for study purposes).
MODEL STRUCTURE
The decision problem at the SBU level may be decomposed in two subproblems: the investment
decision (how much to invest in each project) and the financing decision (what funds to borrow to
invest in each project). These decision subproblems may be modeled through the traditional de-
terministic approach (via NPV and IRR) or through shareholder value based deterministic ap-
proach (via EVA and MVA). Either approach may be employed to allocate the available re-
sources among the projects. Under competitive pressure, the resource e allocation process has an
essentially dynamic nature and includes the extreme cases of suspending temporarily the develop-
ment of a project or even discarding a project altogether.
The main problem at the project level is to forecast and evaluate the cash flows of each project.
This problem may be modeled by either a deterministic or a stochastic approach. Under the de-
terministic approach, each project is defined by a single cash flow that is evaluated by the
NPV/IRR methods. Under the stochastic approach, each project is defined by several cash flows,
depending on the scenarios under analysis, that are evaluated by the CAPM.
The structure of the SUN model is presented below. This structure emphasizes that, under the
SBU point of view, a project is an investment which will produce economic results (energy sales,
for instance). Under the project point of view, the SBU is a lending entity. In this model, the capi-
tal required to start (and maintain) a project is obtained from the SBU, which procures capital
from shareholders and/ or capital markets.
FINANCIAL SHARE
MARKET HOLDERS
th tt
>| SBU
Project
1
Project
2
Project
m
The purpose of the SUN model is to measure the financial-economic performance of SBU and
projects under two aspects: value and risk. Given basic inputs (like capital outlays, receivables
and capital structure) the model calculates deterministic indices (NPV, EVA, MVA) and a sto-
chastic index (Beta) for each project and for the SBU as a whole. The combined use of risk and
return indicators provides a complete framework to evaluate assets at the SBU and project levels.
The SUN model has a modular structure, where each module calculates a group of model vari-
ables. The computational implementation of the model is supported by the shell Powersim. Model
inputs are stored in a text file and a subset of parameters (policy levers) may be changed by slide
bars at simulation time, thus facilitating sensitivity analysis.
The model was developed under the system dynamics framework. The figure below presents a
high level causal loop diagram of the SUN model, indicating the cause-effect relationships among
the main variables; the arrows indicate the influence direction.
SBU Level
Capital Structure
Equity
ROE/ROA ae ULLRULSS
a
}
'
L ““NOPAT © EVA/MVA
nw i Na
Debt
Kas - Equity Interests
ise Capital Structure
Outlays and WACC
~)
,
NN]
Net Profit nopatT EVA/MVA
. Se
NPV
Project Level
A graphical interface, a kind of flight simulator, has been developed to ease data handling and the
visualization of the results. Graphical interfaces allow comparison of values and offers subsidies to
decision making. The figure below presents the simulation results for a SBU compound by four
projects.
EVA in 1000 US$ Cash Flow in 1000 US$
— ait
20.00 -100.000-
a oo)
-200.000.
— a)
-300.000.
20.000- 4 4
-400.000-
0 10 20 30 0 10 20 30
CONCLUSIONS
The modeling technique used the SUN model, system dynamics, allows the consideration of “non-
orthodox” structures and costs of capital at the project and SBU levels along the study horizon.
This is possible because it represents the financial-economic problem through feedback loops.
Shareholder value based methods (EVA/MVA) complement the more traditional NPV/IRR ap-
proaches, whereas CAPM permits the inclusion of a explicit risk measure at project level, in addi-
tion to the (deterministic) return measures. This is in contrast to the deterministic equivalent of
the discounted cash flow method, where the risk measure is implicit in the discount rate.
The CAPM methodology, complemented by the deterministic ones (EVA/MVA and/or
NPV/IRR), makes the SUN model a flexible decision support tool under different decision cir-
cumstances, from a single project analysis to the evaluation of complex restructuring decisions
like the acquisition, merger and integration of firms and SBU’s.
REFERENCES
Forrester, J. W. (1968). Principles of Systems. Wright-Allen Press, Inc.
Geraghty, D. and Lyneis, J. (1984). “A New Strategic Model for Electric Utilities’. IEEE Trans.
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Khan, A. M. and Fiorino, D. P. (1992). “The Capital Asset Pricing Model in Project Selection”,
The Engineering Economist. Vol. 37, n° 2.
Lehn, K. and Makhija, A.K. (1995). “EVA & MVA as Performance Measures and Signals for
Strategic Change”. Strategy and Leadership, May-June.
Morozowski, M. and Silveira, F. S. V. (1997). “A Simulation Approach to Financial Planning of
Electric Utilities in Deregulated Business Environments”. Proceedings of 15th International Sys-
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