Question

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 company could spend an additional R10 million at Year 0 to mitigate the environmental problem, however it would not be required to do so. Developing the mine (without mitigation) would cost R60 million, and the expected cash inflows would be R20 million per year for 5 years. If the company does invest in mitigation, the annual inflows would be R21 million. The risk-adjusted WACC is 12%.
Required:
2.1 Calculate the NPV and IRR without mitigation. (5)
2.2 How should the environmental effects be dealt with when evaluating this project? (5)
2.3 Should this project be undertaken? If so, should the company do mitigation? Why or why not? (5)

Answer 1

Answer 2.1:

Without mitigation

Development cost = R60 million = R60,000,000

Annual cash flow = R20 million = R20,000,000

Project life = 5 years

WACC = 12%.

NPV = Annual cash flow * PV of $1 annuity for 5 year at 12% rate - Development cost

= 20000000 * (1 - 1 / (1 + 12%) ⁵) / 12% - 60000000

= R12,095,524.05

To calculate IRR we will use RATE function of excel

IRR = RATE(nper, pmt, pv, fv, type)

= RATE (5, 20000000, -60000000, 0, 0)

= 19.86%

Hence:

NPV = R12,095,524.05

IRR = 19.86%

Answer 2.2:

As a good corporate citizen the mining company should evaluate the environmental effects. Although company has got permission and it is not legally required, in future it will create issues and a good company has to think long term and do what is required to remain sustainable.

It should evaluate the project with mitigation measures in place and if financials result positive NPV, it should rather mitigate environmental effects.

Answer 2.3:

Let us evaluate the financials with mitigation:

Development cost = R60 million + R10 million = R70,000,000

Annual cash flow = R21 million = R21,000,000

NPV = 21000000 * (1 - 1 / (1 + 12%) ⁵) / 12% - 70000000

= R5,700,300.24

IRR = RATE (5, 21000000, -70000000, 0, 0) = 15.24%

As such with mitigation also we have:

NPV = R5,700,300.24

IRR = 15.24%

With mitigation also the project has positive NPV and has IRR greater than WACC. The project is acceptable with mitigation also.

Although NPV will lesser with mitigation as compared to NPV without mitigation, considering factors as stated in answer 2.2 above, company should do mitigation and implement the project.