Group 8 Acid Rain.docx.docx

SLOAN SCHOOL OF BUSINESSMASSACHUSETTS INSTITUTE OF TECHNOLOGYMEMORANDUM

TO:The Southern Company Board of DirectorsFROM: Group 8: Mrinmay Kulkarni, Matthew Ten Pas, Xin Liu, Ruqing ZhouDATE:August 19, 2014SUBJECT:Impact of Acid Rain Provisions of 1990 Clean Air Act

IntroductionThe effects of the 1990 Clean Air Act threaten the future profitability of the Southern Company. This memo will analyze the available options for a single plant (the Bowen Plant) and provide a recommendation to management that will preserve shareholder value. This recommendation could be extrapolated to similar coal-fired plants that The Southern Company operates.Comparison of OptionsThere are three main options available to respond to the acid rain provisions of the clean air act. The first is to continue operating the plant normally. As of 1995, the plant will need to start buying pollution credits. The cost of these credits will continue to grow at a steady rate and as of 2000 the number of credits The Southern Company needs to buy will significantly increase. By 2010, the company will need to buy $151 million (in nominal terms) in pollution credits annually. This strategy has a net present value of $5,107 million.The second option is to implement the scrubbing technology as soon as possible. Compared to the first option, option two will decrease sales and increase operating costs (that do not include fuel or pollution) starting in 1995. The company will also receive positive cash flows from selling pollution credits from 1995 through 2016. The Southern Company will incur significant costs in implementing the scrubbers in 1992, 1993, and 1994 and these costs will provide some benefit as a tax shield through depreciation the next twenty years. This option has a net present value of $4,922 million.The third option is to switch to low-sulfur coal starting in 1996. Compared to the first option, this will increase fuel costs (due to the projected increase in demand for low-sulfur coal) and create gains from selling tax credits in 96, 97, 98, and 99, and reduce the losses from buying tax credits in 2000 and in future years. It will also require an initial outlay in 1995 which can then be depreciated and used as a tax shield in the next twenty years. This option has a net present value of $5,195.Assuming that there is not a significant consequence in future sales due to any publicity received from choosing one of these options, it would save The Souther Company the most money to choose the option with the highest net present value, which is option 3.Delaying Implementation of ScrubbersDelaying the implementation of the scrubbers by five years increasing the NPV of option two by $160 million to $5081 million. (In this calculation, we assume that the difference between book value and salvage value of the scrubbers in 2016 has a positive tax benefit.) The difference in net present value between option 1 and option 2 is $185 million. This means that choosing to implement the scrubbers is essentially a project with an individual NPV of -$185 million. By delaying the project five years we are essentially discounting the net cost of the project by five years, reducing the number of years that operating costs are increased, and reducing the number of years over which the scrubbers net tax benefits are fully realized. This reduces the net cost of the second option from $185 million to $25 million.Sensitivity AnalysisFuture Price of ScrubbersThe second option is relatively insensitive changes in the salvage value of the scrubbers. To determine this, we assumed there will be a salvage value of 10% of the scrubbers in 2016 and continued to use the same method of depreciation from 1995 to 2015. The new NPV decreases 0.22% from $4,922 million to $4,911million. Therefore, we believe the NPV is not strong sensitive to the future price of scrubbers.Future Prices of Allowances/Growth To test the sensitivity of the options NPV to changes in the value of pollution credits, we discussed two situations in scenario, which are growth rates of 5% and 15%. For option one, when we assume a 15% discount rate, the NPV decreases 5.2% from $5,106.67 million to $4,841.37 million, while NPV increase 1.9% from $5106.67 million to $5,205.70 million with 5% growth rate. For option two, when we assume a 15% growth rate, the NPV increases 3.8% from $4,921.517 million to $5,109.357 million, while NPV decreases 2.6% from $4,921.517 million to $4,844.789 million with a 5% growth rate. For option three, when we assume 15% discount rate, the NPV decreases 2.5% from $5,194.98 million to $5,116.50 million, while NPV increases 0.5% from $5,194.98 million to $5,221.56 million with a 5% growth rate. Therefore, option three is the least sensitive to changes in the growth rate of the value of pollution credits and option three and option 2A relatively sensitive.Conclusion & RecommendationIt is in the best interest of The Southern Companys shareholder to implement option three at the Bowen Plant and continue normal operations until changing to low-sulfur fuel in 1996. This option has the highest net present value and maximizes shareholder wealth, while also significantly reducing the environmental impact of the company. Additionally, this option is less sensitive to some inputs, such as the salvage value of scrubbers and the future value of pollution credits than the other options. The board should strongly consider switching to low-sulfur coal for coal-fired power plants that have similar cost-structures to the Bowen Plant near the year 1995.