Consider the valuation of a power plant that uses gas to produce electricity at 2 dates – the first is

Question:

Consider the valuation of a power plant that uses gas to produce electricity at 2 dates – the first is 6 months from today, and the second one is 1 year from today. The forward prices of electricity with maturities of 6 months and 1 year are 5 and 6 per Mwh, and the forward prices of gas with maturities of 6 months and 1 year are 1 and 1.25 per Mmbtu. The heat rate of the power plant is 10 (it takes 10 units of gas to produce 1 unit of electricity – use the units of the forward prices). The volatility of electricity and gas are 80 percent and 35 percent at an annual rate, and the correlation between electricity and natural gas prices is -0.5. The riskless rate of interest is 4% at annual rate for 6 month and 1 year bonds. Ignore all other costs of running the power plant.

Find the total value of the power plan?

Expert Answer:

Answer rating: 100% (QA)

To find the total value of the power plant we need to calculate the present value of the expected cash flows generated by the power plant at each of t

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