A natural gas energy company must choose between two mutually exclusive extracti

Question

A natural gas energy company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan D, all the natural gas would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan E, cash flows would be $2.1 million per year for 20 years. The firm’s WACC is 13%.

a. Construct NPV profiles for Plans D and E, identify each project’s IRR, and show the approximate crossover rate.

b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 13%? If all available projects with returns greater than 13% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 13% because all the company can do with these cash flows is to replace money that has a cost of 13%? Does this imply that the WACC is the correct reinvestment rate assumption for a project’s cash flows?

Explanation / Answer

b. Yes. Assuming (1) equal risk among projects, and (2) that the cost of capital is a constant and does not vary with the amount of capital raised, the firm would take on all available projects with returns greater than its 13% WACC. If the firm had invested in all available projects with returns greater than 13%, then its best alternative would be to repay capital. Thus, the WACC is the correct reinvestment rate for evaluating a project’s cash flows.

Calculating NPV PLAN-D Cost of the project $12.00M Inflows at end of year 14.4M Pv of annuty factor table @13%@1year 0.885 PV of Inflows (14.4*.885) $12.74M NPV of the project 0.74 M PLAN-E Cost of the project $12.00M Inflows per year $2.1M Pv of compound factor table @13%@20years 7.025 PV of Inflows(2.1M*7.025) $14.75 $14.75M NPV of the project $2.75M Calculation of IRR of the two projects IRR where NPV is Zero PLAN-D WACC 13% 20% Cost of the project 12 12 Inflows at end of year 14.4 14.4 Pv of annuty factor table at end of year 0.885 0.833 PV of Inflows 12.744 12.00 NPV of the project 0.744 0 PLAN-D WACC 13% Cost of the project 12 Inflows at end of year 2.1 Pv ofCumulativ factor table at end of 20 years 7.025 PV of Inflows 14.7525 NPV of the project 2.7525 Cost of the project 12 Inflows at end of year 2.1 Outflows /Inflows(12/2.1) 5.714 5.714 is between 16% and 17% At 16 % 5.929 2.1 12.451 At 17% 5.628 2.1 11.819 0.6321 For 1% diff(12.451-11.819) 0.6321

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