In: Finance
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 $239.99 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 $84.44 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%.
|
a:
With Mitigation | |
NPV | -15.93 |
IRR | 15.5% |
Without Mitigation | |
NPV | 10.18 |
IRR | 19.9% |
b: Option II
If the mitigation is carried out, NPV is negative. But the
company needs to take into account the negative impacts of not
undertaking mitigation.
The environmental effects cannot be ignored and is not sunk cost
but incremental cash outflow. The cost of mitigation is
a certainty. There are various benefits to undertaking
the cost and so it must be assessed.
C: Option III
With mitigation, NPV is negative. So take the project without
mitigation. Properly assess the cost of negative goodwill and
penalties.
The IRR is lesser than the cost of capital and hence With
mitigation option is unviable. However if mitigation is not
undertaken the project is beneficial and hence needs to be
considered.
WORKINGS
Year | Without Mitigation | With Mitigation | |
0 | -239.99 | -279.99 | |
1 | 80 | 84.44 | |
2 | 80 | 84.44 | |
3 | 80 | 84.44 | |
4 | 80 | 84.44 | |
5 | 80 | 84.44 | |
Without Mitigation | With Mitigation | ||
NPV | 10.18 | NPV | -15.93 |
IRR | 19.9% | IRR | 15.5% |