Question

An oil-drilling company must choose between two mutually exclusive extraction projects, and each requires an initial outlay at t = 0 of $11.6 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $13.92 million. Under Plan B, cash flows would be $2.0612 million per year for 20 years. The firm's WACC is 12.2%.

1. Construct NPV profiles for Plans A and B. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. If an amount is zero, enter "0". Negative values, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to two decimal places.

   Discount Rate		NPV Plan A	NPV Plan B
   0%		$ _____million	$ ____ million
   5		____ million	____million
   10		____ million	____ million
   12		____ million	____ million
   15		___ million	____ million
   17		____ million	____ million
   20		____ million	____ million

   Identify each project's IRR. Do not round intermediate calculations. Round your answers to two decimal places.

   Project A: ____ %

   Project B: ____ %

   Find the crossover rate. Do not round intermediate calculations. Round your answer to two decimal places.

   _____ %

2. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 12.2%?

   -Select- Yes or No

   If all available projects with returns greater than 12.2% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 12.2%, because all the company can do with these cash flows is to replace money that has a cost of 12.2%?

   -Select- Yes or No

   Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows?

   -Select- Yes or No

Answer 1

a). Calculation of NPV for Plan A and Plan B :-

Plan A

Net present value (NPV) = Present value of cash inflow - Initial Cash Outlay.

= 13.92 Million / (1 + 0.122)¹ - 11.6 Million

= 13.92 Million / (1.122)¹ - 11.6 Million

= 13.92 Million / 1.122 - 11.6 Million

= 12.4064 Million - 11.6 Million

= $ 0.8064 Million (Rounded off to $ 0.81 Million).

Plan B

Present value of cash inflow = Annual cash inflow * Cumulative present value factors for 20 years at 12.2 % (using present value table)

= 2.0612 Million * 7.3768 (approx)

= $ 15.2051 Million

Accordingly, Net present value (NPV) = Present value of cash inflow - Initial Cash Outlay.

= 15.2051 Million - 11.6 Million

= $ 3.6051 Million (Rounded off to $ 3.61 Million).

Conclusion :-

NPV of Plan A	$ 0.81 Million (approx).
NPV of Plan B	$ 3.61 Million (approx).