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 the 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 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%.

Calculate the NPV and IRR with and without mitigation.

How should the environment effects be dealt with when evaluating this project?

Should this project be undertaken? If so, the firms do the mitigation? Why or why not?

A firm with a WACC of 10% is considering the following mutually exclusive projects

                  0________1_________2_________3__________4____

Project S 1000        870              250                 25                  25

Project L   1000          0                250               400                845

Which project would you recommend?     Explain

Explanation / Answer

NPV Calculation: {Period Cash Flow / (1+R)^T} - Initial Investment

Since the company would get a negative NPV if it invests in mitigation it should not go for mitigation.

Using IRR function in excel on column of cost and revenue without mitigation is 20% and for cost and revenue with mitigation is 15%. Since with mitigation the IRR is lower than WACC it is not advisable for go for the mitigation measure.

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Since the Project L has got a higher NPV and only slightly lower NPV it would be advisable for the firm to go with Project L. However, if the firm is looking for quicker cash flows in the initial years then it can go with Project S as the gestation period is higher in Project L

Year Cost and Revenue without mitigation PV fomula NPV Cost and Revenue with mitigation PV fomula NPV Amount in Million Dollar 0 -240 - -240 -280 -280 1 80 80 / (1 + 0.17) ^ 1 68 84 84 / (1 + 0.17) ^ 1 72 2 80 80 / (1 + 0.17) ^ 2 58 84 84 / (1 + 0.17) ^ 2 61 3 80 80 / (1 + 0.17) ^ 3 50 84 84 / (1 + 0.17) ^ 3 52 4 80 80 / (1 + 0.17) ^ 4 43 84 84 / (1 + 0.17) ^ 4 45 5 80 80 / (1 + 0.17) ^ 5 36 84 84 / (1 + 0.17) ^ 5 38 16 -11

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