Question

An electric utility company is considering construction of a new power facility in Albuquerque, New Mexico. Construction of the plant would cost $275 millioneach year for five years. Expected annual net cash flows are $85 million each year for five years.

Power from the facility would be sold in the Albuquerque and Santa Fe areas, where it is badly needed. The firm has received a permit, so the plant would be legal as currently proposed, but air pollution would be an issue with the new facility.

To alleviate the environmental concerns the company could spend an additional $50 millionwhen the plant is built. The additional funds cover the costs of special equipment designed to minimize the air pollution. At this time, the special pollution-abatement equipment is not required by law. If the firm adds the environmental protections to the facility, the expected annual net cash flows are $90 million for five years.

Unemployment rates are high in the area Where the plant would be built. The plant would provide about 500 new, well-paying jobs.

The risk-adjusted WACC for this project is 15%. As an employee of the utility company, you have been tasked with analyzing the project. You are to make your recommendations to the company’s Board of Directors in a memo.

1. Calculate the NPV, IRR and regular Payback period for this project (with and without the environmental protection equipment).
2. What is your recommendation for the utility company? Provide support for your responses.
3. What additional qualitative/quantitative factors should be considered in accepting or rejecting both versions of this project? The factors might include job creation, salvage value, project life, discount rate (WACC) etc.

Answer 1

With the environmental protection equipment:

NPV:

Year	Cash flows	1+r	PVIF	PV of cash flow
0	-325.00	1.15	1.0000	-325.00
1	90.00		0.8696	78.26
2	90.00		0.7561	68.05
3	90.00		0.6575	59.18
4	90.00		0.5718	51.46
5	90.00		0.4972	44.75
			NPV	-23.31

Thus NPV = -23.31 million.

IRR:

Year	Cash flows	1+r	PVIF	PV of cash flow
0	-325.00	1.11929	1.0000	-325.00
1	90.00		0.8934	80.41
2	90.00		0.7982	71.84
3	90.00		0.7131	64.18
4	90.00		0.6371	57.34
5	90.00		0.5692	51.23
			Total	0.00

Thus IRR = 11.93%

Payback:

Year	Cash flows	Cumulative cash flow
0	-325.00	-325.00
1	90.00	-235.00
2	90.00	-145.00
3	90.00	-55.00
4	90.00	35.00
5	90.00

Payback = 3 + (55/90) = 3.61 years

Without the environmental protection:

Year	Cash flows	1+r	PVIF	PV of cash flow
0	-275.00	1.15000	1.0000	-275.00
1	85.00		0.8696	73.91
2	85.00		0.7561	64.27
3	85.00		0.6575	55.89
4	85.00		0.5718	48.60
5	85.00		0.4972	42.26
			NPV	9.93

NPV = $9.93 million.

IRR:

Year	Cash flows	1+r	PVIF	PV of cash flow
0	-275.00	1.1652	1.0000	-275.00
1	85.00		0.8583	72.95
2	85.00		0.7366	62.61
3	85.00		0.6322	53.74
4	85.00		0.5426	46.12
5	85.00		0.4657	39.58
			NPV	0.00

So IRR = 1.1652 - 1 = 16.52%

Payback:

Year	Cash flows	Cumulative cash flow
0	-275.00	-275.00
1	85.00	-190.00
2	85.00	-105.00
3	85.00	-20.00
4	85.00	65.00
5	85.00

Thus payback = 3 + (20/85) = 3.24 years

On the basis of quantitative capital budgeting tools the construction of the plant without the environmental protection equipment is more feasible as its NPV and IRR is higher and its payback is lower. However I will recommend the project with the environmental protection equipment as it will increase the project's sustainability efforts, reduce pollution and carbon footprint and most importantly will create additional jobs. The benefits of additional jobs will certainly make the project with the environmental protection equipment more attractive. Thus the additional factors that will be considered are ability to create new jobs and impact on environment.

While accepting or rejecting both versions