Question

A Company is involved in searching for locations in which to drill for oil. The firm’s current project requires an initial investment of $25 million and has an estimated life of 12 years. the

firm usually accepts projects that have payback periods between 1 and 4 years. The expected future cash inflows for the project are as shown in the following table.

Year Inflow

1 500,000

2 1,000,000

3 1,000,000

4 2,500,000

5 2,500,000

6 3,000,000

7 3,500,000

8 4,000,000

9 6,000,000

10 8,000,000

11 10,500,000

12 12,000,000

The firm’s current cost of capital is 14%.

TO dO

Create a spreadsheet to answer the following questions.

a. Calculate the payback period for the project. Is the project acceptable under the pay back technique? Explain.

b. Calculate the project’s net present value (NPV). Is the project acceptable under the NPV technique? Explain.

c. Calculate the project’s internal rate of return (IRR). Is the project acceptable under the IRR technique? Explain.

d. In this case, did the two methods produce the same results? Generally, is there a preference between the NPV and IRR techniques? Explain. d.

Answer 1

A)

Cash outflow= 25 million, which means 25000000

year	cash inflow	cumulative cash inflow
1	500000	500000
2	1000000	1500000
3	1000000	2500000
4	2500000	5000000
5	2500000	7500000
6	3000000	10500000
7	3500000	14000000
8	4000000	18000000
9	6000000	24000000
10	8000000	32000000
11	10500000	42500000
12	12000000	54500000

Pay back period= 9 years +[ (25000000-24000000)/ (32000000-24000000) ] * 12

9 years + (1000000/8000000) * 12

9 years + 0.125 * 12

9years and 1.5 months

Payback period = 9.15

The firm prefer payback period in between 1 to 4 years. The project showing a payback period of 9.15, so it is better to reject the project under payback period.

B)

NPV = Present value of cash inflow – Initial investment

year	cash inflow	pvf @ 14%	present value of cash inflow
1	500000	0.8772	438596.4912
2	1000000	0.7695	769467.5285
3	1000000	0.6750	674971.5162
4	2500000	0.5921	1480200.693
5	2500000	0.5194	1298421.661
6	3000000	0.4556	1366759.643
7	3500000	0.3996	1398730.629
8	4000000	0.3506	1402236.219
9	6000000	0.3075	1845047.657
10	8000000	0.2697	2157950.476
11	10500000	0.2366	2484482.456
12	12000000	0.2076	2490709.229
Total present value	17807574.20
(less) cash outflow	-25000000.00
Net Present Value (NPV)	-7192425.80

Considering NPV project showing a negative value, Firm can go for rejection of the project.

C)

IRR = Lowest rate + [(NPV at lowest rate)/(NPV at lowest rate –NPV at highest rate)] * difference in rate

cash flow at lowest rate
year	cash inflow	pvf @ 9%	present value of cash inflow
1	500000	0.9174	458715.5963
2	1000000	0.8417	841679.9933
3	1000000	0.7722	772183.4801
4	2500000	0.7084	1771063.028
5	2500000	0.6499	1624828.466
6	3000000	0.5963	1788801.981
7	3500000	0.5470	1914619.857
8	4000000	0.5019	2007465.119
9	6000000	0.4604	2762566.677
10	8000000	0.4224	3379286.455
11	10500000	0.3875	4069094.929
12	12000000	0.3555	4266416.701
Total present value	25656722.28
(less) cash outflow	-25000000.00
Net Present Value (NPV)	656722.28

(highest rate is taken as 14%, calculation is given above)

       IRR= 9+(656722.28/( 656722.28-(-7192425.8))]*14-9

= 9+[656722.28/7849148.08]*5

= 9+ 0.42

IRR for the project = 9.4%

IRR is not that much higher, Its better to go for Rejection on the basis of IRR

D)

In the current project IRR and NPV shows the same result. Normally a company prefer IRR which is higher (at least higher than the WACC).

Compare between IRR and NPV, it is better to prefer NPV method. NPV will show profit derived from the project where IRR only shows the minimum required rate.