Question

1. 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 million at year 0 to mitigate the environmental problem, but it would not be required to do so. However, if the firm does not deal with the problem at year 0, they would face a lawsuit at the end of project (year 5) at a cost of $20 million. Developing the mine (without mitigation) would cost $60 million and the expected cash inflows would be $20 million for 5 years. The weighted average cost of capital (WACC) is 12%. Below is a summary of possible outcomes:

A. NPV with mitigation costs at time 0 included - $2.1 million

B. NPV without mitigation costs at time 0 and a lawsuit included in year 5 = $0.75 million.

Should the project be undertaken? If so, should the firm do the mitigation at time 0?

a) No, the project is too risky and should not be undertaken.

b) Yes, the project should be undertaken and no mitigation should be conducted at time 0.

c) No, the NPV's are positive for every possible scenario.

d. Yes, the project should be undertaken and the mitigation expense should be conducted at time 0.

Answer 1

Answer: Yes, the project should be undertaken and the mitigation expense should be conducted at time 0.

Justification: The table below summarizes the problem. NPV in both scenarios is positive. It is $2.1 million in case of mitigation and $0.75 million in case of no mitigation. Since the decision rule is to take the option with highest NPV, the project should be undertaken and the mitigation expense should be conducted at time ), so that NPV of $2.1 million can be realized.

		WACC	12%
Years (n)	Mitigation ($ million)	No mitigation ($ million)	Discount factor (1/((1+0.12)^n)	Present Value (with mitigation) Cash flow * discount factor	Present Value (with no mitigation) Cash flow * discount factor
0	-70	-60	1	-70	-60
1	20	20	0.8929	17.86	17.86
2	20	20	0.7972	15.94	15.94
3	20	20	0.7118	14.24	14.24
4	20	20	0.6355	12.71	12.71
5	20	0	0.5674	11.35	0.00
NPV	Sum of all cash flows			2.10	0.75