Question

An oil-drilling company must choose between two mutually exclusive extraction projects, and each requires an initial outlay at t = 0 of $11.2 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $13.44 million. Under Plan B, cash flows would be $1.9901 million per year for 20 years. The firm's WACC is 11.2%.

1. Construct NPV profiles for Plans A and B. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. If an amount is zero, enter "0". Negative values, if any, should be indicated by a minus sign. Do not round intermediate calculations.

   Discount Rate		NPV Plan A	NPV Plan B
   0%		$    million	$    million
   5		million	million
   10		million	million
   12		million	million
   15		million	million
   17		million	million
   20		million	million

   Identify each project's IRR. Do not round intermediate calculations.

   Project A: ?%

   Project B: ?%

   Find the crossover rate. Do not round intermediate calculations.

   ?%

Yes/No questions:

Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 11.2%?

If all available projects with returns greater than 11.2% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 11.2%, because all the company can do with these cash flows is to replace money that has a cost of 11.2%?

Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows?

Answer 1