Question

Business Finance Question 3:

Your firm’s geologists have discovered a small oil field in New York’s Westchester County. The field is forecasted to produce a cash flow of C1 $2 million in the first year. You estimate that you could earn an expected return of r 12% from investing in stocks with a similar degree of risk to your oil field. Therefore, 12% is the opportunity cost of capital. What is the present value? The answer, of course, depends on what happens to the cash flows after the first year. Calculate present value for the following cases:

1. The cash flows are forecasted to continue for 20 years only, with no expected growth or decline during that period

2. The cash flows are forecasted to continue for 20 years only, increasing by 3% per year because of inflation

3. Evaluate the cashflows in a and b and explain which one you will choose and why

Answer 1

a) If No growth rate

present value = cash flow per year * PVAF( 12%,20 years)

= 2,000,000 * { 1 - (1+0.12)-20} / 0.12

= 2,000,000 * 7.469444

= $ 14,938,887.2487

Present value of cash flows if no growth rate = $ 14,938,887.2487 or 14.94 millions

b) If 3% growth rate

Present value = cash flows of year 1 * { 1 - [ (1+g)/(1+r) ]n } / (r -g)

= 2,000,000 * { 1 - [ 1.03 / 1.12]20 } / (0.12 - 0.03)

= 2,000,000 * 9.030737

= $ 18,061,473.1317

Present value of cash flows if 3% growth rate = $ 18,061,473.1317 or 18.06 millions

Here growth 3% is selected because present value of option b is higher than option a