An electric utility is considering a new power plant in northern Arizona. Power

Question

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 million, and the expected net cash inflows would be $80 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $84 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 17%.

a) How should the environment effects be dealt with when evaluating this project?
b) Should this project be undertaken? If so, should the firm do the mitigation?

Explanation / Answer

a) No mitigation analysis

NPV = -240 + 80 (PVIFA @ 17%, 5)

       = -240 + 80*3.1993

       = $15.95 million

NPV = -240 + 80/ (1 + IRR) + 80/ (1 + IRR) 2 + 80/ (1+IRR) 3 + 80/ (1+IRR) 4 + 80/ (1+IRR) 5

At IRR, NPV = 0

0 = -240+80/ (1 + IRR) + 80/ (1 + IRR) 2 + 80/ (1+IRR) 3 + 80/ (1+IRR) 4 + 80/ (1+IRR) 5

Using trial and error method,

IRR = 19.86%

With mitigation analysis

NPV = -280 + 84 (PVIFA @ 17%, 5)

       = -240 + 80*3.1993

       = -$11.25 million

NPV = -280 + 84/ (1 + IRR) + 84/ (1 + IRR) 2 + 84/ (1+IRR) 3 + 84/ (1+IRR) 4 + 84/ (1+IRR) 5

At IRR, NPV = 0

0 = -280+84/ (1 + IRR) + 84/ (1 + IRR) 2 + 84/ (1+IRR) 3 + 84/ (1+IRR) 4 + 84/ (1+IRR) 5

Using trial and error method,

IRR = 15.24%

b) The project is not acceptable when the utility mitigates the environmental effects. However, the company needs to be sure that costs for not mitigating environmental effects has to be considered before company chooses project without mitigation.

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