Externality enterprises are contemplating how to react to California regulations

Question

Externality enterprises are contemplating how to react to California regulations regarding their proposed oil refinery in Redwood City. They face two options. Under option A, the initial investment would cost $0.8B ($800M) to build without fully meeting regulatory requirements. The unit price and variable cost per barrel of this product is estimated to be $150 and $100 respectively. While California would permit this facility to be built, Externality would have to pay a penalty of $15M per year after taxes. Under Option B, the initial outlay for the oil refinery would triple to $2.4 B ($2,400M). However, with the added cost, there would be improvements with regard to increased operating efficiencies and perceived quality.   Estimates suggest that the variable cost per barrel of product would be reduced to $75 and the price that Externality could charge customers would be raised to $200 per barrel. Lastly, there would not be the annual $15M fee imposed by the State of California. Under both conditions, they would expect to produce and sell 5 million barrels per year. Additionally, the initial investment would be expected to have a useful life of 20 years, without any salvage value at the end of the 20 years; for depreciation purposes, straight-line depreciation would be used. The tax rate is 40% and the cost of capital is 16% for both options. Lastly, the pricing, variable costs and demand levels are estimated to be constant for the next 20 years. Which option should Externality choose that would maximize Externality's financial value? How did the California penalty ($15M annually) affect your recommendation? Please support your recommendation with a Net Present Value calculation using discounted cash flow analysis. (A suggestion: keep your answers in the millions---don't get wrapped up around all the zeros; also, you may want to look at 3-33 and 3-35 as this problem is a blend between the two). Externality enterprises are contemplating how to react to California regulations regarding their proposed oil refinery in Redwood City. They face two options. Under option A, the initial investment would cost $0.8B ($800M) to build without fully meeting regulatory requirements. The unit price and variable cost per barrel of this product is estimated to be $150 and $100 respectively. While California would permit this facility to be built, Externality would have to pay a penalty of $15M per year after taxes. Under Option B, the initial outlay for the oil refinery would triple to $2.4 B ($2,400M). However, with the added cost, there would be improvements with regard to increased operating efficiencies and perceived quality.   Estimates suggest that the variable cost per barrel of product would be reduced to $75 and the price that Externality could charge customers would be raised to $200 per barrel. Lastly, there would not be the annual $15M fee imposed by the State of California. Under both conditions, they would expect to produce and sell 5 million barrels per year. Additionally, the initial investment would be expected to have a useful life of 20 years, without any salvage value at the end of the 20 years; for depreciation purposes, straight-line depreciation would be used. The tax rate is 40% and the cost of capital is 16% for both options. Lastly, the pricing, variable costs and demand levels are estimated to be constant for the next 20 years. Which option should Externality choose that would maximize Externality's financial value? How did the California penalty ($15M annually) affect your recommendation? Please support your recommendation with a Net Present Value calculation using discounted cash flow analysis. (A suggestion: keep your answers in the millions---don't get wrapped up around all the zeros; also, you may want to look at 3-33 and 3-35 as this problem is a blend between the two).

Explanation / Answer

OPTION A

Initial Investment = 800 million

Contribution per Unit = (Unit price - Variable Cost per unit) = (150-100) = 50

Units Sold = 5 million

Operating Profit = Units Sold*Contribution = 5*50 = 250 million

Depreciation per year = 800/20 = 40 million

So, EBT = (Operating Profit - Depreciation) = (250-40) = 210 million

Tax = EBT*Tax Rate = 210 * 40% = 84 million

So, Profit After Tax = (EBT -Tax) = (210 - 84) =126 million

Penalty = 15 million

So, Profit post penalty = 126-15 = 111 million

Cash flow from the year's operation = Profit Post penalty + Depreciation = 111+40 = 151 million (As depreciation is a non-cash item, it should be added back)

As, pricing, variable costs and demand levels are estimated to be constant for the next 20 years, we can consider this 151 million as an annuity for next 20 years.

So, present value of annuity = 151 * ((1-1/(1+16%)20)/16%) = 895.25 million [Discounting of annuity cash flow is computed using formula, PV = C * ((1-1/(1+r)t)/r) , here C = 151, r = 16% (cost of capital), t = 20 (number of periods)]

So, Net present Value for Option A = 895.25 - 800 = 95.25 million

OPTION B

Initial Investment = 2400 million

Contribution per Unit = (Unit price - Variable Cost per unit) = (200-75) = 125

Units Sold = 5 million

Operating Profit = Units Sold*Contribution = 5*125 = 625 million

Depreciation per year = 2400/20 = 120 million

So, EBT = (Operating Profit - Depreciation) = (625-120) = 505 million

Tax = EBT*Tax Rate = 505 * 40% = 202 million

So, Profit After Tax = (EBT -Tax) = (505 - 202) =303 million

Cash flow from the year's operation = Profit after tax + Depreciation = 303+120 = 423 million (As depreciation is a non-cash item, it should be added back)

As, pricing, variable costs and demand levels are estimated to be constant for the next 20 years, we can consider this 423 million as an annuity for next 20 years.

So, present value of annuity = 423 * ((1-1/(1+16%)20)/16%) = 2507.90 million

[Discounting of annuity cash flow is computed using formula,  PV = C * ((1-1/(1+r)t)/r) , here C = 423, r = 16% (cost of capital), t = 20 (number of periods)]

So, Net present Value for Option B = 2507.90 - 2400 = 107.90 million

____________________________________________________________________________________________

As, the NPV of option B is greater than NPV of optionA, Option B maximizes Externality's financial value. So, Externality will choose Option B

---------------------------------------------------------------------------------------------------------------------------------------------------------

If there was no penalty for Option A, then yearly inflow for Option A would be = 151+15 = 165 million

In that case, the PV of the future cash flows would be = 165 * ((1-1/(1+16%)20)/16%) = 978.26 million

[iscounting of annuity cash flow is computed using formula,  PV = C * ((1-1/(1+r)t)/r) , here C = 165, r = 16% (cost of capital), t = 20 (number of periods)]

In that case, NPV for option A would be = 978.26 - 800 = 178.26 million, which is greater than that of Option B.

So, if there was no penalty imposed by California, Option A would have been the preferred choice. But as it is not the case, Externality should go ahead with Option B.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.