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 $10.33 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 $63 million, and the expected cash inflows would be $21 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $22 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 should be treated as a sunk cost and therefore ignored.

II. 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.

III. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur.

IV. 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.

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

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 IRR without mitigation is greater than its IRR 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 NPV with mitigation is greater than its NPV 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 without mitigation is greater than its NPV when mitigation costs are included in the analysis.

IV. 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.

V. 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.

Answer 1

S.No.		Cost (in $ Million)	Cash Flows - 5 years (in $ Million)	NPV (in $ Million)	IRR %
A1	Answer :With mitigation ($ 63 Million + $ 10.33 Million)	73.33	22	7.98	15.24%
A2	Answer : Without mitigation ( $ 63 Million + 0)	63.00	21	14.61	19.86%
Workings
Given:	WACC =	11%
	With Mitigation
		CF0	CF1	CF2	CF3	CF4	CF5	NPV
	Cash Flows	-73.33	22	22	22	22	22
NPV Formula	?Cash Flow/ (1+WACC%)^n - Initial Investment	-73.33	19.81982	17.85569	16.08621	14.49208	13.05593	7.979734
IRR formula	?Cash Flow/ (1+IRR%)^n - Initial Investment=0							Total
	@ IRR = 15.24%	-73.33	19.09059	16.56594	14.37517	12.47411	10.82446	0.000283
	IRR	15.24%
	Without Mitigation
		CF0	CF1	CF2	CF3	CF4	CF5	NPV
	Cash Flows	(63.00)	21	21	21	21	21
NPV Formula	?Cash Flow/ (1+WACC%)^n - Initial Investment	-63	18.92	17.04	15.36	13.83	12.46	14.61384
IRR formula	?Cash Flow/ (1+IRR%)^n - Initial Investment=0							Total
	@ IRR = 15.24%	-63	17.52044	14.61742	12.19541	10.17471	8.488832	-0.00318
	IRR	19.86%

Q B

Answer : Choice IV

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.

Mitigation if undertaken may result in lesser NPV and IRR, but will ensure that the river and its eco-system are protected.

Q C) Answer I & III

Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project as the NPV and IRR without mitigation is higher than the NPV and IRR values with mitigation.