Question

An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air pollution. The company could spend an additional $40 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would cost $240.62 million, and the expected cash inflows would be $80 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $85.18 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk adjusted WACC is 18%.

Calculate the NPV and IRR with mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. Do not round your intermediate calculations. For example, an answer of $10,550,000 should be entered as 10.55. Negative value should be indicated by a minus sign.
NPV $   million
IRR %

Calculate the NPV and IRR without mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. Do not round your intermediate calculations. For example, an answer of $10,550,000 should be entered as 10.55.
NPV $   million
IRR %

How should the environmental effects be dealt with when evaluating this project?

The environmental effects should be treated as a sunk cost and therefore ignored.

If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in the original analysis.

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

The environmental effects if not mitigated would result in additional cash flows. Therefore, since the plant is legal without mitigation, there are no benefits to performing a "no mitigation" analysis.

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

Should this project be undertaken?

The project should be undertaken since the NPV is positive under both the "mitigation" and "no mitigation" assumptions.

Even when no mitigation is considered the project has a negative NPV, so it should not be undertaken.

The project should be undertaken only if they do not mitigate for the environmental effects. However, they want to make sure that they've done the analysis properly due to any "ill will" and additional "costs" that might result from undertaking the project without concern for the environmental impacts.

The project should be undertaken only under the "mitigation" assumption.

The project should be undertaken since the IRR is positive under both the "mitigation" and "no mitigation" assumptions.

Answer 1

Initial cost of project without mitigation = $240.62 million
Mitigation cost at year 0 = $40 million
Life 5 year
Cash inflows without mitigation = $80 million
Cash inflows with mitigation = $85.18 million
WACC = 18%

Calculation of NPV and IRR of project without mitigation.
NPV = Present value of cash inflows - Initial cost
= ($80 million * PVAF 5 year 18%) - $240.62 million
= (80 * 3.127) - 240.62
= 250.16 - 240.62 = $9.54 million
IRR is discount rate where NPV is zero. So here following equation must exist:
80 million * PVAF 5 year = 240.62 million
PVAF = 3.00775, Checking PVAF table for this value, it is nearby to 20%. For exact value excel can be used which gives value 19.74%

NPV and IRR of project with mitigation:
NPV = Present value of cash inflows - Initial cost
= (85.18 million * PVAF18%5years) - (240.62 million + 40 million)
= (85.18 miilion * 3.127) - 280.62 million
= 266.35 - 280.62 = -14.27 million
Here the NPV is negative.
IRR :
85.18 * PVAF 5 years = 280.62
PVAF = 3.2944, checking PVAF table, IRR is nearby 16%
Exact IRR is 15.74%

How should the environmental effects be dealt with when evaluating this project?
Ans. must be: The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur.

Should this project be undertaken?
Ans must be: The project should be undertaken only if they do not mitigate for the environmental effects. However, they want to make sure that they've done the analysis properly due to any "ill will" and additional "costs" that might result from undertaking the project without concern for the environmental impacts.