Capital budgeting criteria: ethical considerations An electric utility is consid

Question

Capital budgeting criteria: ethical considerations

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 $240.52 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 $84.95 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 16%.

Calculate the NPV and IRR with mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55.
NPV $_____ million
IRR ________%

Calculate the NPV and IRR without mitigation. Round your answers to two decimal places. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55.
NPV $________million
IRR %_________

Explanation / Answer

(1) Computation of NPV and IRR of the project with mitigation.We have,

   Annual Cash flow = $ 84.95 million

    Number of years = 5

   Initital investment = 240.52 + 40.00 = 280.52 Million

   Cost of Capital    = 16%

(a) Computation of Net Present Value(NPV) of the project.We have,

Step1: Computation of present value of cash inflow. We have

    Present value of Future Cash inflow = Cash Inflow x PVIFA( 16% , 5 Years)

Present value of Future Cash inflow = 84.95 x 3.274 = $ 278.13 million

Step2: Computation of Net Present Value.We have,

NPV = Present Value of Cash Inflow - Cash Outflow

NPV = 278.13 - 280.52 = - $ 2.39 Million

Hence, NPV of project with mitigation is - $ 2.39 million.

(b) Computation of IRR of project.We have,

Step1: Computation of NPV at cost of capital 15%.we have,

    NPV = ( 84.95 X 3.352) - 280.52 = 284.77 - 280.52 = $ 4.46 Million

Step2: Computation of IRR project.We have,

   IRR = 15 +[ 4.46/(4.46 + 2.39) x (16 - 15 ) ] = 15.65 %

Hence, IRR of project with mitigation cost is 15.65%.

(2) Computation of NPV and IRR of project without mitigation Cost.We have,

(a) Computation of NPV of project without mitigation Cost.We have,

NPV of project = ( 80 x 3.274) - 240.52 = $ 21.40 Million

Hence, NPV of the project without mitigation cost = $ 21.40 Million.

(b) Computation of IRR of project without mitigation Cost.We have,

Step1: Computation of NPV of project at cost of capital 20%.We have,

   NPV of project = ( 80 x 2.990) - 240.52 = 239.25 - 240.52 = - $ 1.27 million

Step2: Computation of IRR of project without mitigation Cost.We have,

IRR = 16 + [ 21.40/(21.40 + 1.27) x (20-16)] = 19.78 %

Hence, IRR of project without mitigation Cost is 19.78 %.

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