Question

CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS

An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air pollution. The company could spend an additional $40 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would cost $210.08 million, and the expected cash inflows would be $70 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $76.13 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk adjusted WACC is 17%.

1. Calculate the NPV and IRR with mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. Do not round your intermediate calculations. For example, an answer of $10,550,000 should be entered as 10.55. Negative value should be indicated by a minus sign.
   NPV $   million
   IRR  %

   Calculate the NPV and IRR without mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. Do not round your intermediate calculations. For example, an answer of $10,550,000 should be entered as 10.55.
   NPV $   million
   IRR  %

2. How should the environmental effects be dealt with when evaluating this project?
   1. If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in the original analysis.
   2. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur.
   3. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the plant is legal without mitigation, there are no benefits to performing a "no mitigation" analysis.
   4. The environmental effects should be ignored since the plant is legal without mitigation.
   5. The environmental effects should be treated as a sunk cost and therefore ignored.
   
   -Select- the best choice
3. Should this project be undertaken?
   1. The project should be undertaken since the IRR is positive under both the "mitigation" and "no mitigation" assumptions.
   2. The project should be undertaken since the NPV is positive under both the "mitigation" and "no mitigation" assumptions.
   3. Even when no mitigation is considered the project has a negative NPV, so it should not be undertaken.
   4. The project should be undertaken only if they do not mitigate for the environmental effects. However, they want to make sure that they've done the analysis properly due to any "ill will" and additional "costs" that might result from undertaking the project without concern for the environmental impacts.
   5. The project should be undertaken only under the "mitigation" assumption.
   
   -Select- the best choice

Answer 1

Answer (a)(1):

NPV and IRR with mitigation.

NPV with mitigation = - $6.51 million

IRR with mitigation = 15.86%

Working:

Initial Cost with mitigation = $210.08 + 40 = $250.08 million

Annual cash flows each year for 5 years = $76.13 million

NPV = Annual cash flow * PV of $1 annuity for 5 year at 17% rate - Initial investment with mitigation

= 76.13 * (1 - 1 / (1 + 17%) ⁵) / 17% - 250.08

= -$6.51 million

As annual cash flows are uniform we can use excel function RATE to calculate IRR:

IRR = RATE (nper, pmt, pv, fv, type) = RATE (5, 76.13, -250.08, 0, 0)

= 15.86%

Answer (a)(2):

NPV and IRR without mitigation.

NPV without mitigation = $13.87 million

IRR without mitigation = 19.84%

Working:

Initial Cost without mitigation = $210.08

Annual cash flows each year for 5 years = $70 million

NPV = Annual cash flow * PV of $1 annuity for 5 year at 17% rate - Initial investment without mitigation

= 70 * (1 - 1 / (1 + 17%) ⁵) / 17% - 210.08

= $13.87 million

As annual cash flows are uniform we can use excel function RATE to calculate IRR:

IRR = RATE (nper, pmt, pv, fv, type) = RATE (5, 70, -210.08, 0, 0)

= 19.84%

Answer (b):

Correct answer is:

I. If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in the original analysis.

Explanation:

From answer 1 above, we observe that the project with mitigation has negative NPV and its IRR is less than WACC. As such if the utility mitigates for the environmental effects, the project is not acceptable. However without mitigation project is acceptable since it has positive NPV and its IRR is greater than WACC. Hence project is only acceptable without mitigation and it is essential that before the company chooses to do the project without mitigation, it makes sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in the original analysis.

As such option I is correct and other options II, III, IV and V are incorrect

Answer (c):

Correct answer is:

IV. The project should be undertaken only if they do not mitigate for the environmental effects. However, they want to make sure that they've done the analysis properly due to any "ill will" and additional "costs" that might result from undertaking the project without concern for the environmental impacts.

Explanation:

From answer 1 above, we observe that the project with mitigation has negative NPV and its IRR is less than WACC. As such if the utility mitigates for the environmental effects, the project is not acceptable. However without mitigation project is acceptable since it has positive NPV and its IRR is greater than WACC. Hence project is only acceptable without mitigation and it is essential that before the company chooses to do the project without mitigation, it makes sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in the original analysis.

As such option IV is correct.

Option I is incorrect since decision rule for acceptability of project under IRR rule is IRR > WACC

Option II is incorrect since NPV is negative for the project with 'with mitigation'

Option III is incorrect since with 'no mitigation' NPV is positive.

Option V is incorrect since with mitigation NPV is negative.