Youre the manager of a cash cow business line. You expect (i) to earn profits of $100 million next year, (ii) those profits to grow with the rate of inflation going forward, and (iii) to reap these profits for the next 28 years. The expected rate of inflation is 4.2%, the risk-free rate is 9.8%, the equity premium is 8% and the beta of this business line is 1. However, there is a problem. You face a 15% chance that at the end of your products life you will incur costs of $1 billion (in nominal terms).

Prompt

As you consider the information, answer these questions as a group:

Should you continue to operate the cash cow product line or abandon it?

Your chief engineer comes to you with a proposal that might help reduce the future liability. But her solution is neither costless nor does it eliminate this risk completely. It converts the 15% chance of $1 billion payable in 28 years into a 20% chance of paying $100 million in 10 years. It also requires an upfront investment of $1 million, and annual operating expenses of $1.5 million (which also grow at the rate of inflation).

Should you adopt the engineers solution?

Suppose you operate your production plant in a community of 70,000 people. The pollution you generate causes deaths in the community. The annual mortality rate in the community prior to the plants pollution was about 8.7 per 1,000 inhabitants. With pollution, it rises to 8.8 deaths per 1,000 inhabitants. Assume that the value of a statistical life (VSL) is assessed to be $3.5m in real terms.

What is the present value of lives lost over the 28-year period of operating the plant?

Does your answer to the second part change if the engineers proposed solution eliminates the harmful pollution in the community?