CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS A mining company is consideri

Question

CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS A mining company is considering a new project. Because the mine has received a permit, the project would be legal; but it would cause significant harm to a nearby river. The firm could spend an additional $10 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. Developing the mine (without mitigation) would cost $60 million, and the expected cash inflows would be $20 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $21 million. The risk-adjusted WACC is 12%. 11-8 a. Calculate the NPV and IRR with and without mitigation b. How should the environmental effects c. Should this project be undertaken? If so, should the firm do the mitigation? be dealt with when this project is evaluated?

Explanation / Answer

Case 1: Without mitigation

CF0 = -60 – 10 = -70, CF1-5 = 20

r = WACC = 12%

NPV = -60 + (20/0.12)*(1 – 1/1.12^5) = $12.095524 million

At r = IRR, NPV = 0; as the cash flow is uniform over the period, we can take it as PMT.

PV = 60, PMT = 20, N = 5, FV = 0; compute r = 0.198577 = 19.86%

IRR = 19.86%

Case 2: With mitigation

CF0 = -60, CF1-5 = 21

NPV = -70 + (21/0.12)*(1 – 1/1.12^5) = $5.700300 million

PV = 70, PMT = 21, N = 5, FV = 0; compute r = 0.152382 = 15.24%

IRR = 15.24%

Though both cases generate positive NPV, performing mitigation reduces NPV. Therefore, mitigation is not advisable in terms of monetary benefit of the project.

As both projects have positive NPV, either can be undertaken. But as mitigating is not compulsory, firm should not do the mitigation and can generate higher wealth without mitigation.

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