Question

Problem 6

You are evaluating a project to build an oil pipeline in one of the emerging markets. Building the pipeline will take 8 annual investments, each of which is paid at the beginning of the year, starting immediately. The first of these investments is $20 million and the amount of the remaining 7 investments is expected to decrease by 3% per year. The pipeline will commence its operations in year 9 and will transport 3,500,000 barrels of oil per year in perpetuity. As the pipeline owner, you will collect an annual cash flow equal to 10% of the total value of transported oil, with cash flows occurring at the end of each year.

If the discount rate is 12%, what is the minimum price of oil per barrel under which the Profitability Index is 1.05? For simplicity, assume that oil prices are constant over time and that the costs of running the pipeline are negligible.

Answer 1

Oil Pipeline Project			Investment years								Operating Years
USD Mn			Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7		Year 9 to perpectuty
Investment			20.00	19.40	18.82	18.25	17.71	17.17	16.66
Decrease in Investment				3%	3%	3%	3%	3%	3%
Oil transported (Mn Barrels)											3.5
Oil Price (USD per Barrel)											34
Value of the oil (USD Mn)											119
Cashflow for Pipeline Operator (10% of Value of the Oil) CF											11.9
Present Value of Investment (12% Discount rate) ( P/ (1+12%)^year -1 )	94.75	12%	20.00	17.32	15.00	12.99	11.25	9.75	8.44		Perpectual Cash flow (CF / 12%)
Present Value of Cashflow (12% Discount rate) ( CF / (1+12%)^year)	99.17	12%									99.17
The Profitability Index (PI) = (present value of future cash flows)      /       ( Initial investment)
PI	1.05
To achieve PI of 1.05 Oil price should be above 34 USD per barrel.