Your power plant on Gilligan’s Island is producing too much air pollution. The p

Question

Your power plant on Gilligan’s Island is producing too much air pollution. The professor gives you three choices for dealing with this problem: You can pay a pollution tax (Carbon Offsets) onetime of $13,000,000 immediately. You can close the plant and install a power cable from the mainland to the Island. That will cost you $1,000,000 at the end of this year, $3,000,000 at the end of next year and then $750,000 forever for maintenance. You can retrofit the plant with scrubbers to reduce the emissions to make the plant green. That will cost $7.5m at the end of this year and $100,000 for 50-years for maintenance. Assume that the cost of generating power on the mainland is approximately the same as the cost of generating power at your Gilligan’s Island plant. Assume, this comes as a surprise to you and you have not saved any money in reserves and you need to raise capital. Additional information is that market has a 12 percent market risk premium on the power plant with the risk free rate being 5 percent with a company tax rate of 35 percent. Current total raised capital at the power plant: (This will help you calculate the WACC) Debt – 7,000 outstanding bonds, at 7.5% coupon and 20 years to maturity. These bonds pay interest semiannually and quoted price of 108 percent of par. Common Stock -180,000 shares outstanding, selling for $50 per share: Beta .90 CAPM is .118 or 11.8% Preferred Stock – 8,000 shares of 5.5 percent preferred stock outstanding, currently selling for $95.00 per share. Choose the best option for Gilligan's Island.

Explanation / Answer

Market Value of Debt =7000*1000*1.08 7560000 Market Value of Equity =50*180000 9000000 Market Value of Prefered stock =8000*95 760000 And the total market value of the firm is 17320000 cost of equity CAPM RE =5 + .90(12) = 15.8% 15.8 Cost of Debt The cost of debt is the YTM of the bonds =RATE(40,37.5,-1040,1000,0,) *2 7.12% And the aftertax cost of debt is 4.63% The cost of preferred stock is RP = 5.5/$95 = 5.79% WACC Value OF Firm Weight Cost Of Capital Market Value of Debt 7560000 0.43649 7.12 3.107806 Market Value of Equity 9000000 0.51963 4.63 2.405889 Market Value of Prefered stock 760000 0.04388 5.79 0.254065 17320000 WACC 5.77 Decision 1 Payment of (Carbon Offsets) onetime of $13,000,000 1,30,00,000 Decision 2 Year Present Value 5.77% factor Present value 1 10,00,000 0.9454 945448 2 30,00,000 0.8939 2681614 3 7,50,000 750000/.0577 9933775 Present value 16625328 Decision3 Year Present Value 5.77% factor Present value 1 75,00,000 0.9454 7090858 2 1,00,000 1324503 Present value 8823960 Present Value Decision 1 1,30,00,000 Decision 2 16625328 Decision 3 8823960 Chose decision 3

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