Question

Turn to the Right Drilling Co. (“TTR Drilling”) operates an aging fleet of offshore drilling rigs that are contracted to major integrated oil companies for exploration and production. Since the recent Deepwater Horizon disaster in the Gulf of Mexico, the majors have shown a strong preference for the safer, more technologically-advanced newbuild rigs and are willing to lease these rigs at higher rates than the older ones. Consequently, TTR Drilling is considering replacing their older rigs to take advantage of the higher potential dayrates for their contracts over the next five years. TTR’s current fleet produces annual revenues of $35 M per rig with cash costs of $16 M per rig. The older rigs also currently have $5 M tied up in NWC per rig. The CFO of the company has estimated annual revenues for newbuild rigs at $185 M per rig with cash costs of $30 M per rig. The new rigs would require $15 M in NWC each. The purchase price of a new rig is $750 M. They expect to depreciate this on a straight-line basis to zero over the next five years. However, the company estimates that a new rig could be sold for $400 M at the end of the project. If they purchased a new rig today, they could sell an old one on the open market for $30 M. The old rigs are currently carried on the books at $35 M each and are being depreciated on a straight-line basis by $5 M per year. If they decided to stick with the old rigs, they expect them to have a market value of only $15 M in five years. Assume that TTR Drilling faces a 40% corporate tax rate and an 19% cost of capital. What is the NPV of the decision (in $M per rig) to replace the old vessels with the new ones? (Hint: There is a very similar HW problem in your text.)

Answer 1

Based on calculations below, the net present value if the decision to replace oil rig with new one will have a negative value of $295.5 million. the decision may not be fruitful for TTR drilling mainly because of higher corporate tax rate and higher cost of capital.

all amounts in million:

Cost of capital	19.00%
Steps	Desc	cash flow Y0	cash flow Y1	cash flow Y2	cash flow Y3	cash flow Y4	cash flow Y5
A	Initial investment	(750)
B	annual revenue		185	185	185	185	185
C	operating costs		30	30	30	30	30
D	nwc		15	15	15	15	15
E	Earnings before Tax [=B-C-D]		140	140	140	140	140
F	Corporate Tax [=E x 40.0%]		56	56	56	56	56
G	salvage value (of old rig AT BEGINNING and the new rig after 5 years)	30					400
H	Cash Flow of the decision [E-F+G]	(720)	84	84	84	84	484
Net Present Value (NPV)	(-750,000,000/(1+19%)^0) + (114,000,000/(1+19%)^1) + (84,000,000/(1+19%)^2) + (84,000,0000/(1+19%)^3) + (84,000,0000/(1+19%)^4) + (484,000,000/(1+19%)^5)	(295.54)