Running Head: FINANCIAL MODELS IN PROBLEM SOLVING 1

Critical Assignment

Student’s Name and Number:

Course Code and Name:

Instructor’s Name:

Institution Affiliation:

Date of Submission:
AIR POLLUTION 2

Introduction

The issue of air pollution is a growing concern for many industries. In order to curb such
a situation, three options were brought up which were focused on identifying a solution and
presenting it to management. The main problem is that the powerplant is producing too much air
pollution. The powerplant is located on a small vacation island and provides power to most of
the island, however, technology has grown since the powerplant was built in the 1970s. The main
goal is to provide multiple solutions to solve this problem. By providing multiple solutions to
solve this problem, the management would be in a position to choose the best solution. Finding
the solution to the pollution problem would make a significant contribution to the
company/industry. The three options after calculation gave three different NPV values. Among
the three options none is viable to solve the problem since the NPVs are negative. I’ll however
choose option 3 which had the highest NPV though negative.

The project options

Option 1: Since the small island has been hurt by a downshift in tourism, we could help the
economy by providing a one-time “tax” for the pollution. This would present an immediate
Carbon Offset of $13,000,000. I know some of the senior members of the management would
like to use this as a marketing tool and know the money could be used to help the local
government fund items that were cut because of previous missed tax revenues from the lack of
tourism to the island.

Option 2: The powerplant could be shut down completely and we could install a power cable that
runs from one of the other nearby islands that has a powerplant. This powerplant will still
produce just as much pollution as the one on our island, but it is under a different government
that does not care about air pollution. This would cost the cost our company $1,000,000 at the
AIR POLLUTION 3

end of the year, $3,000,000 at the end of next year and $1,000,000 yearly thereafter for
maintenance. 

Option 3: The powerplant can be retrofitted with scrubbers that can reduce the pollution
emissions and make the powerplant green. The cost of this project would be $7,500,000 at the
end of this year and $100,000 for the next 50-years for maintenance.

Market Conditions

The current market conditions have a 12 percent market risk premium on the powerplant with the
risk-free rate being 5-percent. The local government has a fixed tax rate of 35 percent. Senior
management will ask about the cost to raise capital and we will have to calculate the WACC.
The current capital structure of the company is as follows: 

 Debt –  7,000 outstanding bonds, at 7.5% coupon and 20 years to maturity. These bonds
pay interest semiannually and quoted a price of 108 percent of par.  
 Common Stock -180,000 shares outstanding, selling for $50 per share: Beta .90. 
 Preferred Stock – 8,000 shares of 5.5 percent preferred stock outstanding, currently
selling for $95.00 per share. 

Working;

WACC calculation

WACC = Wd * Kd * (1-Tax rate) + We*Ke + Wp*Kp

Face Value of the bonds= $1000

Value of 1 bond = 108% * 1000 = $1080

Total
Number Value Value Weight
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Common
Stock 180000 50 9000000 51.96%

Debt 7000 1080 7560000 43.65%

Prefereed
Stock 8000 95 760000 4.39%

1732000
Total 0

Cost of Equity using CAPM = Rf + Beta (Rm -Rf) = 5% + 0.9 *12% = 5% + 10.8% = 15.8%
Cost of Debt is the YTM on the bonds:

=RATE(20,7.5,-108,100)

The cost of debt comes out to be 6.76% to the nearest whole number 7%
Cost of preferred stock (assuming a par value of $100) = Preferred dividend/ price of preferred
stock

                          = 5.5/95 = 5.79%

Now the WACC for the company is

Cost of Tax Weight Average

Weight Debt shield Cost

Common
Stock 51.96% 15.80% 0 8.21%

Debt 43.65% 6.76% 35% 1.92%

Prefereed
Stock 4.39% 5.79% 0 0.25%
 AIR POLLUTION 5

WACC 10.38%

Option 1
Paying a pollution tax (Carbon Offsets) onetime of $13,000,000 immediately which has a NPV
of -$13,000,000
Option 2
Closing the plant and installing a power cable from the mainland to the Island.

Cash Flows are

Cash
Year Flows

0        0

    -
1 1000000

    -
2 3000000

3 to     -
infinity 750000

Terminal Cash flow at the end of year 2 = Cash Flow in year 3 / WACC
NPV = -1000000/(1 + 10.38%)1 - 3000000/(1 + 10.38%)2 - (750000/10.38%) / (1 + 10.38%)2
         
  = -$-9,496,485.525
Option 3
Retrofitting the plant with scrubbers to reduce the emissions to make the plant green.

Cash Flows and NPV are as follows:(assuming maintenance starts from year 2 onwards)

Discounted Cash
Year Cash Flows Flows
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0 0 0

1 -7500000 -6794595.95

2 -100000 -82073.84

3 -100000 -74354.48

4 -100000 -67361.15

5 -100000 -61025.57

6 -100000 -55285.88

7 -100000 -50086.03

8 -100000 -45375.24

9 -100000 -41107.53

10 -100000 -37241.21

11 -100000 -33738.53

12 -100000 -30565.29

13 -100000 -27690.50

14 -100000 -25086.10

15 -100000 -22726.66

16 -100000 -20589.13

17 -100000 -18652.64

18 -100000 -16898.29
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19 -100000 -15308.94

20 -100000 -13869.07

21 -100000 -12564.63

22 -100000 -11382.88

23 -100000 -10312.28

24 -100000 -9342.37

25 -100000 -8463.68

26 -100000 -7667.64

27 -100000 -6946.47

28 -100000 -6293.13

29 -100000 -5701.23

30 -100000 -5165.01

31 -100000 -4679.22

32 -100000 -4239.12

33 -100000 -3840.42

34 -100000 -3479.21

35 -100000 -3151.98

36 -100000 -2855.52

37 -100000 -2586.95
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38 -100000 -2343.64

39 -100000 -2123.21

40 -100000 -1923.51

41 -100000 -1742.60

42 -100000 -1578.70

43 -100000 -1430.22

44 -100000 -1295.70

45 -100000 -1173.83

46 -100000 -1063.43

47 -100000 -963.41

48 -100000 -872.80

49 -100000 -790.71

50 -100000 -716.34

51 -100000 -648.96

NPV -7660970.82

NPV of option 3 is -$-7,660,970.82

Conclusion
Among the three options, Option 3 is the best option to deal with problem since it has the
highest NPV though negative. This implies that the present value of the expected benefits such
as cost savings and revenue generation from option 3 is greater than the present value of the
expected costs associated with it such as capital investment and operating expenses over the
project's lifetime (Brigham and Ehrhardt, 2019). In other words, it suggests that option 3 will
AIR POLLUTION 9

generate the most economic value or profit for the company compared to the other options. This
could be because option 3 may offer the most cost-effective solution for reducing air pollution
while also generating revenue or other benefits.
However, it's important to note that NPV alone may not be sufficient to determine the
best option (Yang and Zhang, 2022). Other factors such as feasibility, technical and operational
considerations, social and environmental impacts, and risk management must also be considered
to ensure that the chosen option is sustainable and aligned with the company's long-term goals
and values. Therefore, a comprehensive evaluation of all available options is necessary before
making a final decision.
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10

References

Brigham, E. F., & Ehrhardt, M. C. (2019). Financial management: Theory & practice. Cengage

Learning.

Yan, R., & Zhang, Y. (2022, March). The Introduction of NPV and IRR. In 2022 7th

International Conference on Financial Innovation and Economic Development (ICFIED

2022) (pp. 1472-1476). Atlantis Press.