Question
Fixing our Environment Externality enterprises are They face two options. Under option A, the initial investment would cost so 8B ($80oM) to build react to ia regulations regarding their proposed oil refinery in Redwood City how to without fully meeting regulatory requirements. The unit price and variable cost parrel of this product is estimated to be $150 and S100 respectively. While California would permit this facility to be built, Externality would have to pay a penalty of $15M per year after taxes Under Option B, the initial outlay for the oil refinery would triple to $2.4 B (S2,400M). However, with the added cost, there would be improvements with regard to increased operating efficiencies and perceived quality Estimates suggest that the variable cost per barrel of product would be reduced to $75 and the price that Externality could charge customers would be raised to S200 per barrel Lastly, there would not be the annual $15M fee imposed by the State of California. Under both conditions, they would expect to produce and sell 5 million barrels per year. Additionally, the initial investment would be expected to have a useful life of 20 years, without any salvage value at the end of the 20 years; for depreciation purposes, straight-line depreciation would be used The tacrale is 40% and the cost of capital is le% for both options. Lasty, the pricing, variable costs and demand levels are estimated to be constant for the next 20 years Which option should Externality choose that would maximize Externality's financial value? How did the California penalty ($15M annually) affect your recommendation? Please support your a Net Present Value calculation using discounted cash flow analysis. A suggestion: keep your answers in the millions-dont get wrapped up around all the zeros; also, you may want to look at 3-33 and 3-35 as this problem is a blend between the two).
Explanation / Answer
Calculation of NPV:
From the calculation made in the table above, it is clear that the net present value under option A is positive while Option B results in a negative net presnt value. Thus, its is appropriate to choose Option A over option B.
California penalty is considered in option A alone as it does not exist in Option B. Also, since it is expressly mentioned that it is after tax, the amount of penalty is deducted from the net cash flows after tax.
Option A Option B Cash inflow per annum: Price per barrel $150 $200 Variable cost per barrel 100 75 Net cash inflow per barrel 50 125 Net cash inflow per 5 million barrels $250 m $625 m Less: tax @ 40% (100) m (250) m Cash inflow after taxes 150 m 375 m Less: Penalty (15) m 0 Net cash inflow after taxes 135 m 375 m Present value annuity factor @ 16% 5.929 5.929 Present value of cash flow 800.415 m 2223.375 m Less: Initial cash outlay (800) m (2400) m Net present value
0.415 m (176.625)
