Wind power investment decision analysis

Wind Power

An opportunity has arisen to invest in wind power. The startup costs of this investment are fixed, but the expected future cash flows are not. These are dependent on the level of adoption of wind power in society. This in turn depends on the price of oil. The higher the price of oil goes, the more people will use my wind power. However, if the price of oil drops, fewer people will use wind power.

To decide whether to invest in wind power, we need to estimate the expected outcome of our investments. The simplest method of doing this is to take a weighted average of the expected payoff. Given that each investment is scaled evenly, we only need to worry about the percentage gains. Thus:

15% chance of making 300% + 50% chance of making 140% + 35% chance of making 90% = expected payoff.

The expected payoff therefore is 146.5%. Thus the $5,000 investment will return $7,325. Based on the expected outcome, I should invest in wind power.

There are other methods of determining whether or not to invest. Risk aversion is a common method. Most people are risk averse. Therefore, they would steer away from investments that have a strong chance of losing money, even if the potential gains are substantial. In this situation, the loss would not be significant, so risk aversion is a poor method of making this decision. However, if the potential losses were greater and my risk aversion higher, then the decision to invest would be more difficult. One factor that contributes to higher risk aversion is the amount of different investments. If this was my only investment, I would be more likely to be risk averse. The weighted average of expected outcomes theory is advisable not so much for a single game, but for a series of games. While I could lose on this particular investment, if I made this investment several times, I would come out ahead with a 146.5% payoff.

It should be noted that a key step in this process is to evaluate the quality of the estimates. The expected value of future cash flows is only as valuable at the information that goes into deriving them. It is a situation of garbage in, garbage out. In this case, the different weightings came from one analyst, who based his decisions on OPEC's informational output. OPEC may have been attempting to obfuscate its future policy direction in order to ward off oil speculators, or the analyst may have misinterpreted OPEC's communiques. In either case, it would have been advisable to gather information from more analysts before making the weightings.

There are also capital budgeting techniques that could be applied in this scenario. For example, if the up-front costs are known, that provides a starting point for a net present value analysis. In this case, we do not have any way of deriving a cost of capital nor do we have a clear sense of the future cash flows. So we cannot accurate use a capital budgeting model or subject it to a sensitivity analysis.