Question

The following data have been collected by capital budgeting analysts at Condel Brothers Oil Co. concerning the drilling and production of known reserves at an off-shore location:

Investment in rigging equipment and related personnel costs required to pump the oil	$	5,300,000
Net increase in inventory and receivables associated with the drilling and production of the reserves. Assume this investment will be recovered at the end of the project		1,200,000
Net cash inflow from operations for the expected life of the reserves for years:
Year 1		2,000,000
Year 2		3,600,000
Year 3		1,700,000
Salvage value of machinery and equipment at the end of the well’s productive life		1,000,000
Cost of capital		18	%

(a.) Calculate the net present value of the proposed investment in the drilling and production operation. Ignore income taxes, and round answers to the nearest $1.
(b.) What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

Answer 1

Year	Cash Flow	Present Value (Note-2)
0	-530	-530
1	200	200
2	360	258.55
3	390 (Note-1)	237.37
NPV (Note-3)	165.91
IRR (Note-4)	32%

Note-1

3rd Year Cash Flow is sum of Salvage Value of Machinary ($100) plus Net Increase in Inventory and Receivable ($120) and 3rd year cash inflow ($170).

Note-2

Present Value = Cashflow(1+interest)^Year

Year 0=530/(1+0.18)^0

Year 1= 200/(1+0.18)^1

Year 2=360/(1+0.18)^2

Year 3=390/(1+0.18)^3

Note-3

Sum of All Present Value=-530+200+258.55+237.37=$165.91

a) So the NPV of this Project is $165.91 i.e $166(appx).

b)The internal rate of return on this investment be relative to the cost of capital is 32%.It is calculated as below

IRR=lower discount rate chosen+ (NPV at lower discount rate/ NPV at lower discount rate-NPV at higher discount rate)* (higher discount rate- lower discount rate)

=10%+(260.53/260.53-165.91)*(18%-10%)=32%