Question

CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS

A mining company is considering a new project. Because the mine has received a permit, the project would be legal; but it would cause significant harm to a nearby river. The firm could spend an additional $9.66 million at Year 0 to mitigate the environmental Problem, but it would not be required to do so. Developing the mine (without mitigation) would cost $57 million, and the expected cash inflows would be $19 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $20 million. The risk-adjusted WACC is 11%. a. Calculate the NPV and IRR with mitigation. Round your answers to two decimal places. Do not round your intermediate calculations. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55.

NPV $ ________ million

IRR ________ %

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

NPV $ ________ million

IRR ________ %

b. How should the environmental effects be dealt with when this project is evaluated?

I. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the mine is legal without mitigation, there are no benefits to performing a "no mitigation" analysis.

II. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur. III. The environmental effects if not mitigated could result in additional loss of cash flows and/or fines and penalties due to ill will among customers, community, etc. Therefore, even though the mine is legal without mitigation, the company needs to make sure that they have anticipated all costs in the "no mitigation" analysis from not doing the environmental mitigation.

IV. The environmental effects should be ignored since the mine is legal without mitigation.

V. The environmental effects should be treated as a sunk cost and therefore ignored.

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c. Should this project be undertaken? _________________

If so, should the firm do the mitigation?

I. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its NPV without mitigation is greater than its NPV when mitigation costs are included in the analysis.

II. Under the assumption that all costs have been considered, the company would mitigate for the environmental impact of the project since its IRR with mitigation is greater than its IRR when mitigation costs are not included in the analysis.

III. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its NPV with mitigation is greater than its NPV when mitigation costs are not included in the analysis.

IV. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its IRR without mitigation is greater than its IRR when mitigation costs are included in the analysis.

V. Under the assumption that all costs have been considered, the company would mitigate for the environmental impact of the project since its NPV with mitigation is greater than its NPV when mitigation costs are not included in the analysis.

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Answer 1

Solution:

	Life of the mining project	5 years
		All amounts in million $
a)		With mitigation of environmental problem		Without mitigation of environmental problem
		Year 0	Year 1 to Year 5	Year 0	Year 1 to Year 5
1	Cost of developing the mine	57		57
2	Cost of mitigating the environmental problem	9.6		0
	Total Outflow,PVO	66.6		57
3	Annual inflows per year	0	20		19
	PV of annual inflows at WACC 11% p.a,PVI		=(Annual inflow*(1-(1+r)^-n)/r		=(Annual inflow*(1-(1+r)^-n)/r
	where n=5 and r=11%		=(20*(1-(1+11%)^-5))/0.11		=(19*(1-(1+11%)^-5))/0.11
			73.92		70.22
4	NPV=PVI-PVO		NPV=73.92-66.6= $ 7.32 million		NPV=70.22-57= $ 13.22 million
5	IRR is the rate at which NPV becomes zero and is calculated using the formula		r0+              (NPV r0) *r1-r0		r0+              (NPV r0) *r1-r0
			NPV r0- NPV r1		NPV r0- NPV r1
	Lets assume r0 as 11% and r1 as 15%
	PVI at discount rate of 15%		=(20*(1-(1+15%)^-5))/0.15		=(19*(1-(1+15%)^-5))/0.15
			67.04		63.69
			NPV=PVI-PVO=67.04-66.6= $ 0.44 million		NPV=PVI-PVO=63.69-57= $ 6.69 million
	IRR		=11%+((7.32/(7.32-.44))*(15%-11%))		=11%+((13.22/(13.22-6.69))*(15%-11%))
			15.26%		19.10%
	Hence ,with mitigation, NPV is $7.32 million and IRR is 15.26%
	Without mitigation,NPV is $13.22 million and IRR is 19.10%
b)	Answer is III
c)	Answer is I. NPV is a better technique of evaluating a project as IRR has inherent limitations.In the problem, NPV without mitigation of the environmental problem is high