Timing Differences The Ewert Exploration Company is considering two mutually exc

Question

Timing Differences

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $9.5 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t = 1 of $10.5 million; under Plan B, cash flows will be $1.4 million per year for 20 years.

What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B rather than Plan A? (Hint: Subtract Plan A's flows from B's.)

If the company accepts Plan A and then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B? Round your answer to two decimal places.
%

Suppose a firm’s cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10%, because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project’s cash flows? The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Explanation / Answer

1. Year Incremental Cash Flow (B - A) Year 1 -9.1 2-20 Years 26.6 2. If r is the re-investment rate, then equating the extra cash generated in Plan A ,to the 2---20 years of annitous cash flows of 1.4 9.1=1.4*(1-(1+r)^-19)/r Solving for r, r=the re-investment rate= 14.14% No. It cannot take on all available independent projects (of average risk) with returns greater than 10% ,as it also depends on the total funds available for capital budgeting purposes. Even then, projects are chosen by applying various selection criteria, like the net present value of the project's cash flows, profitability index,pay-back period in years and   modified internal rate of return. So, it is not logical to assume that all projects with returns >10% COC ,can be accepted. Also it cannot be assumed that cash flows from past investments would have an opportunity cost of only 10%, as the funds might have been acquire at more or lesser rates. Cost of capital is the weighted average cost of all the sources of finance ,to the company --with which it is going to fund the capital project & naturally aims to earn atleast that rate from this new investment.So,COC is a bench-mark or a cut-off rate ,which gives a feeling of security in the minds of the invetsor, of having achieved the minimum hurdle-rate. Anything above is considered surplus from the investment.

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