Proposed pollution control project -memorandum, Financial Management

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Memo to: Blackwater plc Main Board.

Subject: Proposed Pollution Control Project.

From: Lower down the hierarchy.

Date: That'll be the day.

On purely non-financial criteria it is able to be suggested that as a regular violator of the environmental regulation our company has a moral responsibility to install this equipment so long as it doesn't jeopardise the long-term survival of the company.

But the figures appended propose that the project isn't wealth-creating for Blackwater's shareholders as the EV of the fines is less than the expected NPV of the project. Nevertheless this conclusion relies on accepting the validity of the probability distribution which is debatable. Not merely are the magnitudes of the fines merely estimates but the probabilities shown are subjective. Different decision-makers may possibly well arrive at different assessments which could lead to the opposite decision on financial criteria.

More basically the use of the expected value principle is only reliable when the probability distribution approximates to the normal. In this situation it is slightly skewed toward the lower outcomes. But more considerably if the distribution itself is examined more closely it appears to indicate that there is a 70% chance (0.5+0.2) of fines of at least $ 1 4m which exceeds the NPV of the costs of the pollution control project. In other phase there is a 70% chance that the project will be valuable. It so seems perverse to reject it on these figures.

Furthermore given that Blackwater is a persistent offender as well as that the green lobby is becoming more influential there should be a strong likelihood that the level of fines will increase in the future suggesting that the data given are under-estimates. Higher expected fines would additionally enhance the appeal of the project.

It is as well possible that the company may sell more output perhaps at a higher price if it is perceived to be more environmentally friendly and if customers are swayed by this. This may be less probable for industrial companies although it would create opportunities for self-publicity on both sides. Additionally there may be more general image effects which may foster enhanced self-esteem among the workforce as well as increasing the acceptability of the company in the local community.

It is still possible that the company's share price may benefit from managers of ethical investment funds deciding to comprise Blackwater in their portfolios.

Finally this may be merely a short-term solution. As the operating life of the equipment is merely four years we will face a further investment decision after this period although technological and legal changes may well have altered the situation by then.

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