In: Finance
Payback period and NPV calculations) Plato Energy is an oil and gas exploration and development company located in Farmington, New Mexico. The company drills shallow wells in hopes of finding significant oil and gas deposits. The firm is considering two different drilling opportunities that have very different production potentials. The first is in the Barnett Shale region of central Texas and the other is in the Gulf Coast. The Barnett Shale project requires a much larger initial investment but provides cash flows (if successful) over a much longer period of time than the Gulf Coast opportunity. In addition, the longer life of the Barnett Shale project also results in additional expenditures in year 3 of the project to enhance production throughout the project's 10-year expected life. This expenditure involves pumping either water or
CO 2CO2
down into the wells in order to increase the flow of oil and gas from the structure. The expected cash flows for the two projects are as follows:
LOADING...
.
a. What is the payback period for each of the two projects?
b. Based on the payback periods, which of the two projects appears to be the best alternative? What are the limitations of the payback period ranking? That is, what does the payback period not consider that is important in determining the value creation potential of these two projects?
c. If Plato's management uses a discount rate of
21.621.6
percent to evaluate the present values of its energy investment projects, what is the NPV of the two proposed investments?
d. What is your estimate of the value that will be created for Plato by the acceptance of each of these two investments?
Year |
Barnett Shale |
Gulf Coast |
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0 |
$(4 comma 600 comma 0004,600,000) |
$(1 comma 100 comma 0001,100,000) |
||||
1 |
1 comma 840 comma 0001,840,000 |
825 comma 000825,000 |
||||
2 |
1 comma 840 comma 0001,840,000 |
825 comma 000825,000 |
||||
3 |
(920 comma 000920,000) |
375 comma 000375,000 |
||||
4 |
1 comma 840 comma 0001,840,000 |
120 comma 000120,000 |
||||
5 |
1 comma 640 comma 0001,640,000 |
|||||
6 |
1 comma 640 comma 0001,640,000 |
|||||
7 |
1 comma 640 comma 0001,640,000 |
|||||
8 |
850 comma 000850,000 |
|||||
9 |
650 comma 000650,000 |
|||||
10 |
150 comma 000150,000 |
a) | ||||||
PBP | Project Barnett Shale | Project Gulf Coast | ||||
Time | Amount | Cumulative | Amount | Cumulative | ||
- | (4,600,000.00) | (4,600,000.00) | (1,100,000.00) | (1,100,000.00) | ||
1.00 | 1,840,000.00 | (2,760,000.00) | 825,000.00 | (275,000.00) | ||
2.00 | 1,840,000.00 | (920,000.00) | 825,000.00 | 550,000.00 | ||
3.00 | (920,000.00) | (1,840,000.00) | 375,000.00 | 925,000.00 | ||
4.00 | 1,840,000.00 | - | 120,000.00 | 1,045,000.00 | ||
5.00 | 1,640,000.00 | 1,640,000.00 | ||||
6.00 | 1,640,000.00 | 3,280,000.00 | ||||
7.00 | 1,640,000.00 | 4,920,000.00 | ||||
8.00 | 850,000.00 | 5,770,000.00 | ||||
9.00 | 650,000.00 | 6,420,000.00 | ||||
10.00 | 150,000.00 | 6,570,000.00 | ||||
Payback period | 4 Years | 1 + 275,000 /825,000 | ||||
Payback period | 4 Years | 1.33 Years | ||||
b) Project Gulf Coast as it has payback period of 1.33 Years | ||||||
Paybackignores time value of money and ingores future cash flows once investment is recovered | ||||||
c) | ||||||
Statement showing Cash flows | Project Barnett Shale | Project Gulf coast | ||||
Particulars | Time | PVf 21.6% | Amount | PV | ||
Cash Outflows | - | 1.00 | (4,600,000.00) | (4,600,000.00) | (1,100,000.00) | (1,100,000.00) |
PV of Cash outflows = PVCO | (4,600,000.00) | (1,100,000.00) | ||||
Cash inflows | 1.00 | 0.8224 | 1,840,000.00 | 1,513,157.89 | 825,000.00 | 678,453.95 |
Cash inflows | 2.00 | 0.6763 | 1,840,000.00 | 1,244,373.27 | 825,000.00 | 557,939.10 |
Cash inflows | 3.00 | 0.5562 | (920,000.00) | (511,666.64) | 375,000.00 | 208,559.77 |
Cash inflows | 4.00 | 0.4574 | 1,840,000.00 | 841,556.97 | 120,000.00 | 54,884.15 |
Cash inflows | 5.00 | 0.3761 | 1,640,000.00 | 616,844.89 | - | |
Cash inflows | 6.00 | 0.3093 | 1,640,000.00 | 507,273.76 | - | |
Cash inflows | 7.00 | 0.2544 | 1,640,000.00 | 417,165.92 | - | |
Cash inflows | 8.00 | 0.2092 | 850,000.00 | 177,807.60 | - | |
Cash inflows | 9.00 | 0.1720 | 650,000.00 | 111,817.86 | - | |
Cash inflows | 10.00 | 0.1415 | 150,000.00 | 21,220.49 | - | |
PV of Cash Inflows =PVCI | 4,939,552.03 | 1,499,836.97 | ||||
NPV= PVCI - PVCO | 339,552.03 | 399,836.97 | ||||
d) | Project Barnett Shale | Project Gulf coast | ||||
Value created | 339,552.03 | 399,836.97 | ||||