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 in a percentage?

b-2. (Yes or No) 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.) Opportunity cost of capital for this investment is calculated using the difference between payoff at the end of the year 1 over the amount investment divided by the investment made in a single peice of the carbon sequesters.
     Opportunity cost of capital = (Payoff at end of year 1 - Investment) / Current Investment
                                                = ($135,660 - $114,000) / $114,000
                                                = 0.19
                                                = 19%

b-1.) The opportunity cost of capital in case the sequested carbon has to be sold on the London Stock Exchange is equal to the average rates of return on investments that is 24%

b-2.) No, The purchase of additional sequesters is not an attractive investment for the firm as the investment in no longer risk free and now depends on the price of carbon and keeping the expected return to be at 19% it fetches less return as compared to the other investments on London Stock Exchange