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 $210.27 million, and the expected cash inflows would be $70 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $76.22 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 %

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

1. If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will" for not mitigating for the environmental effects have been considered in that analysis.

2. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur.

3. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the plant is legal without mitigation, there are no benefits to performing a "no mitigation" analysis.

4. The environmental effects should be ignored since the plant is legal without mitigation.

5. The environmental effects should be treated as a sunk cost and therefore ignored.

Should this project be undertaken?

1. The project should be undertaken since the IRR is positive under both the "mitigation" and "no mitigation" assumptions.

2. The project should be undertaken since the NPV is positive under both the "mitigation" and "no mitigation" assumptions.

3. Even when no mitigation is considered the project has a negative NPV, so it should not be undertaken.

4. The project should be undertaken only if they do not mitigate for the environmental effects. However, they want to make sure that they've done the analysis properly due to any "ill will" that might result from undertaking the project without concern for the environmental impacts.

5. The project should be undertaken only under the "mitigation" assumption.

Explanation / Answer

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

5. The environmental effects should be treated as a sunk cost and therefore ignored.

Should this project be undertaken?

5. The project should be undertaken only under the "mitigation" assumption.

WITH MITIGATION: NPV: PV of cash inflows = 76.22*PVIFA(16,5) = 76.22*3.2743 = $    249.57 million Less: Initial cost $    250.27 million NPV $       -0.70 million IRR: IRR is that discount rate for which PV of cash inflows=PV of cash outflows So, 250.27 = 76.22*PVIFA(I,5), where i=IRR Solving for IRR 3.2835 = PVIFA(I,5) IRR lies between 15% and 16%. 15% 16% It is by simple interpolation, 15+(3.3522-3.2835)/(3.3522-3.2743) = 15.88% 3.3522 3.2743 The project is not acceptable as the NPV is negative. WITHOUT MITIGATION: NPV: PV of cash inflows = 70.00*PVIFA(16,5) = 70.00*3.2743 = $    229.20 million Less: Initial cost $    210.27 million NPV $       18.93 million IRR: IRR is that discount rate for which PV of cash inflows=PV of cash outflows So, 210.27 = 70.00*PVIFA(I,5), where i=IRR Solving for IRR 3.0039 = PVIFA(I,5) IRR lies between 19% and 20%. 19% 20% It is by simple interpolation, 19+(3.0576-3.0039)/(3.0576-2.9906) = 19.80% 3.0576 2.9906 The project acceptable as the NPV is positive.

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