An oil drilling company must choose between two mutually exclusive extraction pr
ID: 2739864 • Letter: A
Question
An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12.2 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.64 million. Under Plan B, cash flows would be $2.1678 million per year for 20 years. The firm's WACC is 11.4%.
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.
%
Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 11.4%?
-Select-yesnoItem 18
If all available projects with returns greater than 11.4% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 11.4%, because all the company can do with these cash flows is to replace money that has a cost of 11.4%?
-Select-yesnoItem 19
Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows?
-Select-yesnoItem 20
Explanation / Answer
NPV plan A:
NPV = Present value of cash inflows – Present value of cash outflows
= $14.64 (0.897666) - $12.20
= $13.14183 - $12.20000
= $ 0.94183
NPV plan B:
NPV = Present value of cash inflows – Present value of cash outflows
= $2.1678 (7.759438) - $12.20
= $16.820911 - $12.20000
= $ 4.620911
IRR of Project A:
Discount rate is taken at 22%:
NPV = Present value of cash inflows – Present value of cash outflows
= $14.64 (0.897666) - $12.20
= $11.99999 - $12.20000
= - $ 0.20000
Project A
Internal Rate of Return = R1 + NPV1*(R2-R1)
(NPV1-NPV2)
= 11.4 + $ 0.94183 * (22%-11.4%)
$ 0.94183-(-$0.20000)
= 20.14% (rounded)
IRR of Project B:
Discount rate is taken at 22%:
NPV = Present value of cash inflows – Present value of cash outflows
= $2.1678 (4.460266) - $12.20
= $9.668965 - $12.20000
= - $ 2.531035
Project B
Internal Rate of Return = R1 + NPV1*(R2-R1)
(NPV1-NPV2)
= 11.4 + $ 4.620911 * (22%-11.4%)
$ 4.620911-(-$2.531035)
= 18.24% (rounded)
No, company cannot take all independent projects with returns greater than 11.4% because the tenusre of project, certainty of cash flows and many other points to be considered.
No, All the companies cannot take the same % of return and it varies according to the company and its risk profile.
WACC is not the correct re-investment rate but IRR is the correct reinvestment rate.