Question

Your boss believes the company's power plant is producing too much air pollution on a typical island. Your boss gives you three choices for dealing with this problem because he/she does not want to deal with it:

1. You can pay a pollution tax (Carbon Offsets) one time of $13,000,000 immediately.  
2. You can close the plant and install a power cable from the mainland to the Island. That will cost you $1,000,000 at the end of this year, $3,000,000 at the end of next year and then $750,000 forever for maintenance.  
3. You can retrofit the plant with scrubbers to reduce the emissions to make the plant green. That will cost $7.5m at the end of this year and $100,000 for 50-years for maintenance.  

Assume that the cost of generating power on the mainland is approximately the same as the cost of generating power at the Island's plant. Assume, this comes as a surprise to you and you, have not saved any money in reserves, and you need to raise capital. Additional information is that market has a 12 percent market risk premium on the power plant with the risk-free rate being 5 percent with a company tax rate of 35 percent.  

Current total raised capital at the power plant:  (This will help you calculate the WACC)

• Debt – 7,000 outstanding bonds, at 7.5% coupon and 20 years to maturity. These bonds pay interest semiannually and quoted a price of 108 percent of par.  
• Common Stock -180,000 shares outstanding, selling for $50 per share: Beta .90.
• Preferred Stock – 8,000 shares of 5.5 percent preferred stock outstanding, currently selling for $95.00 per share.

Please answer in essay format and provide your Excel document showing all your calculation in appendixes choose the best option for Island. Support your answer with your calculations. Also, to calculations use specified resources, other appropriate scholarly resources, including older articles.

Answer 1

Step 1. Compute WACC

WACC = Wd*Kd(1-t) + Wp*Kp + We*Ke Where:

Wd =percentage of debt in the capital structure 0

Wp=percentage of preferred stock in the capital structure

We=percentage of common stock in the capital structure

OPTIMAL CAPITAL STRUCTURE

Equity=180000x50=$9000, 000

Preferred=8000 x5.5=$44,000

Debt=7000 x108=$756000

Total=9000000+440000+756000=$9,800,000

Then compute the weight of each

Equity=9000000/9800000 x100=91.8%

Preferred=44000/9800000 x100=0.44%

Debt=756000/980000 x100=7.71%

Compute cost of each component

Equity use CAPM

= 0.05+0.9 (0.12-0.05) =11.3%

Preferred

Ks=D/r

Dividends paid=5.5% x95=5.225

Ks=5.225/95=5.5%

Debt- after tax

=7.5(1-t)

7.5 x 0.65=4.9%

WACC= = Wd*Kd(1-t) + Wp*Kp + We*Ke

=4.9 X 0.771+ 5.5 X 0.004+ 11.3 X0.918=14.2

WACC=14.2%

This is the appropriate discounting factor

Evaluate the alternatives

Choice 1: paying pollution taxes

Amount=$13,000,000

Choice 2: install power cable

Use Wacc to discount the amounts

1,000,000 x 0.876=875,656.74

3,000,000 x0.767=2,300,324.19

750,000 /0.142=5,281690.14

Total=8, 457671.071

Choice 3:

7500000 x0.876=6,570,000

100000 xpvif of annuity

100000 x7.033=703, 304.04

Total=7, 273304.04

Decision

The firm should choose choice three that is to retrofit the plant with scrubbers to reduce the emissions to make the plant green that will cost $7.5m at the end of this year and $100,000 for 50-years for maintenance. This is because it has the lowest costs