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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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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 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%.

  1. a. Calculate the NPV and IRR with and without mitigation.
  2. b. How should the environmental effects be dealt with when evaluating this project?
  3. c. Should this project be undertaken? If so, should the firm do the mitigation? Why or why not?

a.

Summary Introduction

To calculate: The NPV and IRR of the given project with and without mitigation.

Introduction:

Capital Budgeting:

It refers to the long term investment decisions that has been taken by the top management of a company and that are irreversible in nature. These decisions require investment of large amount of the company’s cash.

Net Present Value (NPV):

It is a method under capital budgeting which includes the calculation of net present value of the project in which the company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after considering the discounted rate.

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital.

Explanation

Given information:

  • Cost of the project with mitigation is $280 million and without mitigation is $240 million.
  • Life of the project is 5 years.
  • Cash inflow expected per year with mitigations is $84 million and without mitigation $80 million.
  • Cost of capital is 12%.

The calculation of NPV and IRR with mitigation on spreadsheet is:

b.

Summary Introduction

To identify:  The way in which the environmental effects should be dealt with when this project is evaluated.

c.

Summary Introduction

To explain: Whether the project should be undertaken or not with or without mitigation.

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