Case Write-Up on Acid Rain

Sloan School of Management

Massachusetts Institute of Technology

15.415 Financial Theory

Case Write-Up: Acid Rain

(Due date: Monday, August 3, 2015)

Prepared by:
Ramneik Bathla (MIT ID: 925348738)

George Ma (MIT ID: 912867931)

Mandy Wu (MIT ID: 925472294)

Kendra Yan (MIT ID: 923415107)

Daoyuan Zhu (MIT ID: 921899542)

To: The Management Council of The Southern Company,

We present our findings with regards to The Southern Company (“the company”)’s strategy going forward in compliance with the Clean Air Act (1992).

The terms of reference for this study is to consider the three options available to the company in response to the Clean Air Act, namely 1) keep the status quo and purchase allowances, 2) install scrubbers to reduce emission and 3) switch with low emission coal, and to offer our recommendations. The detailed operational data for the options are available in Annex A.

For this study, we will assume in our estimations that

1. Revenue of the firm is constant throughout the operational period of the firm, and more importantly the revenue is independent of the option adopted by the firm. This allows us to focus on the cost differences of each option.
2. The operating cost of the plant is constant throughout the operational period of the firm.
3. The price of allowance will rise by 10% through to the year 2010 and stay constant thereafter.
4. The project starts from the end of 1992. Hence, the cash flow in 1992 is not discounted, and we start discounting cash flow from 1993.
5. The capitalized interest is calculated compoundly.
6. The company has sufficient other sources of profits to use up the depreciation tax benefits in the given year without deferring them to the next year.

Taking into account these assumptions and the operational data, we have calculated the NPV, using the formula CF = (1-r) operating profits – capital expenditures + r depreciation, for the 3 options as follow:

Given the assumption that total revenues are independent of the option taken, we can therefore conclude that option 3 incurs the lowest cost to the company. The precise calculations of the NPVs are available in annex B.

Concerning option 2, the company also has the option to delay the installation of the scrubbers for 5 years. The associated NPV of this strategy is 5,093.55M and this is a more attractive option than early installation because the savings from additional operating cost and energy cost outweigh the losses from the allowance.  The precise calculation of this NPV is available in annex C.

• When the project ends, scrubber still has 48M worth of salvage value. We assume the company can sell the expenditure to gain cash inflow.

As a robustness test of our study, we relaxed some of our assumptions to examine its impact of our NPV estimates.

• If we change the growth of future allowance price, the NPV for the 3 options are as follow:

• If we change the price of the base allowance in 1995, the NPV for the 3 options are as follow:

• If we change the price of the scrubbers installation, the NPV for the options are as follow:

From these analysis, we observe that adjusting the assumptions do not affect the relative ranking of the 3 options and option 3 remains the most attractive option. Furthermore, option 3 is least sensitive to the changes.

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