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 $24 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would cost $204 million, and the expected cash inflows would be $54 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $74 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 10%. a) Calculate the IRR without mitigation. b) Calculate the IRR with mitigation.

Explanation / Answer

a) NPV without mitigation Initial investment 204 million Cash Inflows 54 million Number of years 5 then NPV = CF * (1 - ( 1+I)-n) / I - initial investment                     = 54 *(1 - (1 + 0.10)-5)/0.10 - 204                     = 54 * ( 1 - 0.6209) /0.10 - 204                     = 54 * 0.3791/0.10 - 204                      = 54 * 3.791 - 204                       = 204.71- 204                       = 0.71 As NPV is very close to 0, IRR is 10% b) NPV with mitigation Initial investment 228 million Cash Inflows 74 million Number of years 5 WACC 10% then NPV = CF * (1 - ( 1+I)-n) / I - initial investment                     = 74 * ( 1- (1+0.19)-5/0.19 - 228                     = 74 * ( 1-0.4190 )/0.19 - 228                     = 74 * 0.5810/0.19 - 228 226.2846                    =   74*3.0579   - 228                     = 226.28-228                     = -1.72 As NPV is very close to 0, IRR is 19%

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