Due to recent environmental regulations your firm must cut it\'s CO_2 emissions

Question

Due to recent environmental regulations your firm must cut it's CO_2 emissions by 50%. If the firm doesn't install the equipment it can pay an annual penalty of $12,000 to continue the operating. There are two options for reducing emissions. In order to incentivize firms to cut emissions the government accepts part of installation and operational expenses of emission control (up to some cap) as tax deductible expenses. Your company beta is 1.5, the risk-free rate is 4%, and market risk-premium is 8%. Marginal tax rate for your company is 20%. Calculate the IRR and NPV of each option. Which strategic decision will you make? Are you going to install any equipment or going to pay the fine and not install any option? If there is no option to pay the penalty (in other words you have to install the equipment) which option will you choose?

Explanation / Answer

1-

2

2- we shall go for installation of project or option B because it is having a positive NPV of 17613 and project A having a negative NPV of -9886. we will not pay any penalty due to cash outflow of 12000 every year with any savings.

3- we will install the option B having higher IRR and Positive NPV

Option A 0 Saving operating exp (dep and allowable exp) Saving Tax@20% Saving after tax add dep and allowable exp Savings after tax before dep Present value factor @10% present value of cash flow 1 12000 0 5000 7000 1400 5600 5000 10600 0.909091 9636.363636 2 12000 0 5000 7000 1400 5600 5000 10600 0.826446 8760.330579 3 12000 0 5000 7000 1400 5600 5000 10600 0.751315 7963.93689 4 12000 0 5000 7000 1400 5600 5000 10600 0.683013 7239.942627 5 12000 0 5000 7000 1400 5600 5000 10600 0.620921 6581.766024 6 12000 0 5000 7000 1400 5600 5000 10600 0.564474 5983.423659 6 7000 0.564 3948 Sum of discounted cash inflow 50113.76341 Sum of discounted cash Outflow 60000 NPV of Project A -9886.23659 IRR 5.03% Option B 0 Saving operating exp (dep and allowable exp) Saving Tax@20% Saving after tax add dep and allowable exp Savings after tax before dep Present value factor @10% present value of cash flow 1 12000 6000 4000 2000 400 1600 4000 5600 0.909091 5090.909091 2 12000 6000 4000 2000 400 1600 4000 5600 0.826446 4628.099174 3 12000 6000 4000 2000 400 1600 4000 5600 0.751315 4207.362885 4 12000 6000 4000 2000 400 1600 4000 5600 0.683013 3824.87535 5 12000 6000 4000 2000 400 1600 4000 5600 0.620921 3477.159409 6 12000 6000 4000 2000 400 1600 4000 5600 0.564474 3161.054008 7 12000 6000 4000 2000 400 1600 4000 5600 0.513158 6157.897419 8 12000 6000 4000 2000 400 1600 4000 5600 0.466507 5598.088563 9 12000 6000 4000 2000 400 1600 4000 5600 0.424098 5089.17142 10 12000 6000 4000 2000 400 1600 4000 5600 0.385543 4626.519473 10 5000 5000 0.350494 1752.469497 sum of discounted cash inflow 47613.60629 Sum of discounted cash outflow 30000 NPV of the project 17613.60629

2

IRR 17.55%

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