Question

Pollution Busters Inc. is considering a purchase of 10 additional carbon sequesters for $114,000 apiece. The sequesters last for only 1 year before becoming saturated. Then the carbon is sold to the government.

a. Suppose the government guarantees the price of carbon. At this price, the payoff after 1 year is $135,660 for sure. How would you determine the opportunity cost of capital for this investment?

b-1. Suppose instead that the sequestered carbon has to be sold on the London Carbon Exchange. Carbon prices have been extremely volatile, but Pollution Busters’ CFO learns that average rates of return from investments on that exchange have been about 24%. She thinks this is a reasonable forecast for the future. What is the opportunity cost of capital in this case?

b-2.  If the expected return on the investment is still 19%, but instead depends on the price of carbon (so that it is no longer risk-free), then is the purchase of additional sequesters an attractive investment for the firm?

Answer 1

a) Oppertunity cost of capital

Opportunity cost of capital = (Payoff after year 1 - Current Investment price) / Current Investment price

Current investment - $114000

Payoff after year 1 - $135660

Opportunity cost = (135660-114000)/114000

= 21660/114000 = .19 or 19%

Oppertunity cost of capital = 19%

b-1) Opportunity cost of capital for the investment is the average rate of return from an investment in on that exchange

So, here the opportunity cost of capital is 24%

b-2) Purchase of the additional sequesters is not a worthwhile investment because as purchase of additional carbon sequesters provides less expected return (19%) than it would earn in London Carbon Exchange (i.e 24%)