Question

our 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)

4. 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.  
5. Common Stock -180,000 shares outstanding, selling for $50 per share: Beta .90.
6. 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

Answer 1

Here, the question is based on the concept of decision making in finance to reduce the net impact of pollution in power manufacturing plant at an island.

Step 1: calculate WACC for the company by use of

where, W_e ,W​​​​p, W _d are weight of equity , preference , and debt in total capital

K_e and K_p are cost of equity and preference share

I is interest , and T = tax rate

K_e = Risk free rate + Beta * Market risk free = 5+0.9*12= 15.8%

Total value of capital = Value of equity + Value of debt + Value of Preference share

Total value of capital = 180,000*50+7000*108+8000*95 = 10516000

W_e = 180,000*50/10516000 = 0.8558 ,

W​​​​p=8000*95/10516000 =0.0723 ,

W _d=7000*108/10516000 = 0.0719

WACC =(0.8558 *15.8%)+(0.0719 *7.5%(1-35%))+(0.0723*5.5%) = 14.2698%

Step 2: Analysis of all the available options with concept of Present value of cost involve .

Discount rate = WACC= 14.2698%

Option 1
Cost	-$1,30,00,000.00
Year	0
PV of cost	-$1,30,00,000.00
Option 2
Cost	-$10,00,000.00
Year	1
PV of cost	-$8,75,121.86	1000000/(1+0.142698)
Cost	-$30,00,000.00
Year	2
PV of cost	-$22,97,514.81	3000000/(1+0.142698)^2
Cost	$7,50,000.00
Year	for ever
PV of cost	-$52,55,855.02	750000/0.142698
Total PV Cost of option 2	-$84,28,491.70
Option 3
Cost	-$75,00,000.00
Year	1
PV of cost	-$65,63,413.96	7500000/(1+0.142698)
Cost	$1,00,000.00
Year	for 50 year
PV of cost	-$6,99,891.45	PV(14.2698%,50,100000)
Total PV Cost of option 3	-$72,63,305.41

As option 3 has the lowest total cost  

Step 3: selection of Option ,

The company should prefer option 3,  retrofit the plant with scrubbers to reduce the emissions to make the plant green. That will cost $7.5 million at the end of this year and $100,000 for 50-years for maintenance.