Pollution Busters Inc. is considering a purchase of 10 additional carbon sequesters for $120,000 apiece. The sequesters last for only 1 year before becoming saturated. Then the carbon is sold to the government. a. Suppose the government guarantees the price of carbon. At this price, the payoff after 1 year is $140,400 for sure. How would you determine the opportunity cost of capital for this investment? b-1. Suppose instead that the sequestered carbon has to be sold on the London Carbon Exchange. Carbon prices have been extremely volatile, but Pollution Busters’ CFO learns that average rates of return from investments on that exchange have been about 22%. She thinks this is a reasonable forecast for the future. What is the opportunity cost of capital in this case? b-2. If the expected return on the investment is still 17%, but instead depends on the price of carbon (so that it is no longer risk-free), then is the purchase of additional sequesters an attractive investment for the firm?

(a) 17% (b) the purchase of additional sequesters an attractive investment for the firm is worthwhile investment if no other similar project offers a higher return of over 17%, which in this case here is 17%.

Explanation:

Solution:

(a) Calculate the opportunity cost of capital

Opportunity cost of capital = pay off at one year/Current investment

= $140,400-$120,000/$120,000

=20,400/120,000 = 0.17 or 17%

What it means is that, the project offers a guarantee of 17% return. it should be accepted unless another project offers a higher return of over 17%

(b) The opportunity cost of capital, if the sequestered carbon has to be sold on the London Carbon Exchange which is simply the average rate of return of investment.

Therefore the opportunity cost per capital in this case is 22%

The purchase of additional sequesters an attractive investment for the firm is worthwhile investment if no other similar project offers a higher return of over 17%, which in this case here is 17%.