W timing pattern. Why is there a conflict -CAPITAL B UDGETING CRITERIA: ETHICAL

Question

W timing pattern. Why is there a conflict -CAPITAL B UDGETING 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. he firm does invest in mitigation, the annual inflows would be $21 million. The risk-adjusted WACC is 12% a. Calculate the NPV and IRR with and without mitigation. b. How should the environmental effects be dealt with when this project is evaluated? c Should this project be undertaken? If so, should the firm do the mitigation?

Explanation / Answer

a. With mitigation:

NPV = sum of all discounted cash flows. Initial cash outflow = 60+10 = 70 million.

Thus NPV (in $ million) = -70+present value factor of annuity of $1 (12%,5 years)*21

From the PVIFA table we see that present value factor of annuity of $1 (12%,5 years) = 3.6048

Thus NPV = -70+(3.6048*21) = $5.70 million

IRR is the rate which makes NPV as nil. Let irr be x%. Thus -70+21/(1+x)^1 + 21/(1+x)^2 + 21/(1+x)^3 + 21/(1+x)^4 + 21/(1+x)^5 = 0

Solving the above equation mathematically we get x = 15.24%. Thus IRR = 15.24%

Without mitigation:

NPV = -60+present value interest factor of $1 (12%,5 years)*20

= -60*(3.6048*20)

= $12.10 million.

IRR: Let IRR be x%. Thus -60+20/(1+x)^1 + 20/(1+x)^2 + 20/(1+x)^3 + 20/(1+x)^4 + 20/(1+x)^5 = 0

Solving the above equation we get x = 19.86%. Thus IRR = 19.86%

b. Environmental effects could be added by estimating penalties or any other cash outflows that might be imposed on the company. These outflows could be so large as to cause the project to have a negative NPV, in which case the project should not be undertaken.

c. The project without mitigation should be undertaken because NPV without mitigation is higher than NPV with mitigation, its NPV is positive and its IRR is greater than the company’s cost of capital. Thus if the firm is only considering the financials then it should not do mitigation. But if qualitative factors are considered and the firm will want to account for the long term ramifications of not doing the mitigation then it should do the mitigation (as IRR in case of mitigation is 15.24% and this is higher than WACC of 12%).

With mitigation Without mitigation NPV (in $ million) 5.70 12.10 IRR (in %) 15.24 19.86

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