You own an oil pipeline that will generate a $2.4 million cash return over the c

Question

You own an oil pipeline that will generate a $2.4 million cash return over the coming year. The pipeline’s operating costs are negligible, and it is expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 3.5% per year. The discount rate is 8%.

a. What is the PV of the pipeline’s cash flows if its cash flows are assumed to last forever? (Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.)

Present value            $

b. What is the PV of the cash flows if the pipeline is scrapped after 18 years? (Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.)

Present value            $

Explanation / Answer

Solution: a) Cash Flows are assumed to be last forever, Growth perpetuity formula with a negetive growth rate: Present Value= $2.4 million /(0.08- (-0.035)) Present Value= $2.4 million /0.115 = $ 20.87 million b) Oil Pipeline's Value at year 18 assuming its cash flows last forever is: Present Value(at 18 year)= Cash Flows at year 19/ (rate of return - growth rate)   Present Value(at 18 year)= Cash Flows at year 1 (1+g)^18/ (rate of return - growth rate) Present Value(at 18 year)= ($ 2.4 million)*(1-0.035)^18/(0.08 - (-0.035))   Present Value(at 18 year)= $1.26387 million/0.115 = $ 10.99 million Present Value = $20.87 million - $10.99 million / (1.08)^18 Present Value = $20.87 million - $2.75 million= $18.12 million

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