Question

CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS An electric utility is consider-ing 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 addi-tional $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 cash inflows would be $80 million per year for 5 years. If the firm does invest in mitiga-tion, 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.

Explain without excel

Answer 1

Initial cash outlay without Mitigation = $240 million

Initial cash outlay with Mitigation = 240+40= $280 million

NPV = Initial cash outlay + PV of all the cash inflows

IRR is the interest rate at which NPV = 0

IRR for without mitigation

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

We will solve this for IRR and get IRR = 19.86%

IRR for with mitigation

0 = -240 + (84/((1+IRR)^1)) + (84/((1+IRR)^2)) + (84/((1+IRR)^3)) + (84/((1+IRR)^4)) + (84/((1+IRR)^5))

We will solve this for IRR and get IRR = 15.24%

	Cash Flows (in $ million)
Year	Without Mitigation	With Mitigation
0	-240	-280
1	80	84
2	80	84
3	80	84
4	80	84
5	80	84
NPV	15.95	-11.25
IRR	19.86%	15.24%
Discount rate	17%