Question

2. Zia’s Risky Energy Corporation is evaluating the inclusion of a pollution filtration system. Conduct a Net Present Value analysis and indicate your recommendation to accept or reject the project. The particulars are: The pollution device will cost $450,000. The maintenance will be $34,000 per year. The pollution filtration system needs special filters that will cost $14,000 per year. It is expected that the insurance premium savings will be $15,000 per year. Electricity for the factory lights is $12,000 per year. Loss reduction is expected to amount to $100,000 per year. The screening device has a three year useful life with zero salvage value. The company is in the 35% tax bracket. The cost of capital for the firm is the appropriate discount rate, that rate is 6%. Explain one reason a risk manager could invest in a project that loses money.

Answer 1

Operating cash flow (OCF) each year = incremental income after tax + depreciation

NPV is calculated using NPV function in Excel

NPV is -$214,107

It is recommended to reject the project because the NPV is negative.

A risk manager may invest in a negative NPV project because there may be certain non-quantifiable benefits that accrue due to the project. For example, investing in a pollution control device could help the firm comply with environmental regulations and help build the firm's image and brand value. These factors are not quantifiable in an NPV analysis, but bring benefits to the firm. Thus, a manager may accept such a project even if it has a negative NPV