NPV profiles: timing differences An oil drilling company must choose between two
ID: 2655002 • Letter: N
Question
NPV profiles: timing differences
An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12.6 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $15.12 million. Under Plan B, cash flows would be $2.2389 million per year for 20 years. The firm's WACC is 12.2%.
a. Construct NPV profiles for Plans A and B. Round your answers to two decimal places. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55.
Identify each project's IRR. Round your answers to two decimal places.
Project A _____ %
Project B______ %
Find the crossover rate. Round your answer to two decimal places.
_____%
b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 12.2%? 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%? Yes or No
Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows? Yes or No
Explanation / Answer
Calculation of NPV:
NPV = Present Value of Inflow - Outflow
Outflow = $12.6 million
Present Value of Inflow can be calculated with the help of annuity table because cash flow are even.
IRR: IRR is the rate at which NPV is zero. In the present question, for Plan A = 20%
For Plan B = 17%
Discount Rate NPV Plan A NPV Plan B 0% 2.52 32.18 5 1.8 15.30 10 1.15 6.46 12 0.9 4.12 15 0.55 1.41 17 0.32 0 20 0 -1.70Related Questions
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