Critical Assignment

The problem presented is that the company’s power plant is producing a lot of air
pollution on one of the typical islands. The company can select one option among the three most
viable options. The following is a list of the solutions that can be implemented in creating a
standard outcome for the problem.

1. The organization can consider making payments to the pollution tax once amounting to
   $13,000,000. This should be done immediately.
2. The power plant can be shut down and a power cable installed from the mainland to the
   Island. The cost is expected to be $1,000,000 in the first years and $3,000,000 and
   $750,000 in the second and third year, respectively.
3. It is possible to retrofit the company with the help of scrubbers to limit the emission. The
   cost implication of the design is $7.5 million at the end of the first year and a cash flow of
   $100,000 in the next 50 years.
   The main assumption that needs to be made is that generating electricity on the mainland
   will cost the same as that on the Island. If this assumption does not hold, then the company will
   incur an extra cost. Equally, there is a 12% market risk premium where the risk-free rate stands
   at 5% and a tax rate accumulating to 35%.
   The Weighted Average Cost on Capital will be used to determine the total amount raised.
   Debt = 7,000 bonds, 7.5% coupon, and a maturity period of 20 years. The interest will be
   generated semiannually, and a quotation of 108% of par is provided.
   Common Stock = 180,000 of the shares, each selling at $50 with a beta of 0.90.
   Preferred Stock = 8,000 shares where 5.5% are preferred stock and outstanding, currently
   going for $95.

3
The problem is worsening and this means that a decision has to be made. The best course
of action that the organization can consider is the one that will be cheaper. WACC for the
company will be calculated and offer the needed results to be used in decision making. The face
value of the bond is assumed to be$1,000 at 108%, which will be equivalent to $1,080. Appendix
A shows the total weight and the associated values
In addition, there is a need to calculate the cost of equity, debt, and the preferred common
stock. The equity cost can be determined using the Capital Assets Pricing Model (CAPM).
CAPM = Risk-free rate + Beta(Market Risk-Free Rate based on Return). The formula can be summarized as Rf + Beta(Rm – Rf). So, cost to equity = 5% + 0.912 = 15.8%. In Excel, the rate
formula is applied, which will yield the same outcomes. On the other hand, the cost of preferred
stock will be established by dividing the dividend percentage by the price. Hence, preferred stock
= 5.5/95%100 = 5.79%. The outcomes are indicated in Appendix B
Applying the WACC to the outcomes will lead to discounting factors of 10.38%. (See Appendix
C).
The first outcome is straightforward in offering a solution that can be used to make
payments for the $13,000,000 tax on pollution as an effective option.
The second solution is to consider closing the plant and putting in place power cables.
The Net Present Value (NPV) will be used to evaluate the liability of the option since the cost of
cable installation has been provided (Brigham and Ehrhardt, 2020). The NPV will divide all the
cash flows by the WACC. The table below shows the outcome of the cash flow based on the
excel computation as indicated in Appendix D.

4
A summation of the outcome indicates that the total cost for installing the cable is
$9,297,301.20.
The third option is to consider the installation of scrubbers at the cost of $7,500,000 for
50 years with a spending of $100,000 which will be treated as the maintenance expense. The PV
for each of the respective years will have to be calculated. The WACC at the start discount will
be $7,500,000 and an additional $100,000 for each year after that. The total after 50 years will be
$7,660,597.301, as shown in Appendix E where the discounted amount for each years has been
computed. The end goal is to have the cumulative outcome.
The best option for the company to consider is number three, where there will be the
installation of scrubbers with annual maintenance for 50 years. Paying the pollution tax appears
to be a good solution. However, it is an easy payout of $13,000,000 which will increase in future
base on the carbon emission. Closing down and installing cables will be much cheaper but in the
long run it will change due to higher investment value. Hence shutting down the power plant
might incur other additional expenses in future. On the other hand, installation has a high initial
investment, but there is a saving on cost at the end making it the most suitable alternative to
consider out of the three option. It is cost effective and generating the needed cash flow within
the respective years.

5

References

Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: theory & practice, 16th
edition. Cengage Learning.