CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS An electric utility is considering a new power

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 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. Calculate the NPV and IRR with and without mitigation.b. How should the environmental effects be dealt with when evaluating this project?c. Should this project be undertaken? If so, should the firm do the mitigation?
a. Calculating the NPV of plant With Mitigation Year Cash flows PV at 17% Net Present Value 0 -280000000 1 -28,00,00,000 1 8,40,00,000 0.855 7,17,94,872 2 8,40,00,000 0.731 6,13,63,138 3 8,40,00,000 0.624 5,24,47,127 4 8,40,00,000 0.534 4,48,26,604 5 8,40,00,000 0.456 3,83,13,337 -1,12,54,922 IRR of plant with mitigation Year Cash flows IRR 0 -280000000 1 8,40,00,000 15.24% 2 8,40,00,000 3 8,40,00,000 4 8,40,00,000 5 8,40,00,000 Calculating the NPV of plant without mitigation Year Cash flows PV at 17% Net Present Value 0 -240000000 1 -24,00,00,000 1 8,00,00,000 0.855 6,83,76,068 2 8,00,00,000 0.731 5,84,41,084 3 8,00,00,000 0.624 4,99,49,645 4 8,00,00,000 0.534 4,26,92,004 5 8,00,00,000 0.456 3,64,88,892

1,59,47,693 IRR of plant without mitigation Year Cash flows IRR 0 -240000000 1 8,00,00,000 19.86% 2 8,00,00,000 3 8,00,00,000 4 8,00,00,000 5 8,00,00,000 b. Environment effects should be dealt with extreme care and it should be ensured that no damage is done to flora and fauna of the surroundings. c. As we can see that a project WITH MITIGATION gives a negative NPV, hence we should go with a plant with a positive NPV (project with NO MITIGATION)as it has a positive NPV.

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