Question

Canadian Metal, Mining, and Petroleum Company is analyzing two projects for possible investment. Only one investment will be made. The first project is an oil drilling project in Alberta at a cost of $620 million that will produce $124 million per year in Years 5 through 10 and $260 million per year in Years 11 through 20. The second project is an expansion of an aluminum smelter in Mapletree, Quebec, and will cost $620 million and will produce $111 million per year for Years 2 through 20. The cost of capital is 11 percent.

a-1. Calculate the net present value for each project. (Set calculator to 4 decimal places. Do not round intermediate calculations. Round the final answers to the nearest whole dollar. Enter your answers in whole dollars, not in millions - for example if your answer is 1,000,000 enter 1,000,000 and not 1.)

   

	Net present value
Oil wells	$
Aluminum Smelter	$

a-2. Which investment should be made, if projects are mutually exclusive?

• Oil wells

• Aluminum Smelter

b-1. If the oil-well project justifies an extra 4 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of flows, recalculate the net present value of the mine. (Round "PV Factor" to 3 decimal places. Negative answer should be indicated by a minus sign. Do not round intermediate calculations. Round the final answer to the nearest whole dollar. Enter your answers in whole dollars, not in millions.)

	Net present value
Oil wells	$

b-2. Does the investment decision change?

• Yes

• No

Answer 1

NPV = sum of present value (PV) of all future cash flows

a-1). NPV of Oil wells:

PV of cash flows from Year 11 to Year 20, at time T = 10: PMT*(1-(1+r)^-n)/r = 260,000,000*(1-(1+11%)^-10)/11% = 1,531,200,323

PV of this value at T= 0: 1,531,200,323/(1+11%)^10 = 539,264,988

PV of cash flows from Year 5 to Year 10, at time T = 5: PMT*(1-(1+r)^-n)/r = 124,000,000*(1-(1+11%)^-6)/11% = 524,586,694

PV of this value at T = 0: 524,586,694/(1+11%)^4 = 34,5561,504

NPV at T = 0: -620,000,000 + 34,5561,504 + 539,264,988 = 264,826,491

NPV of aluminum smelter:

PV of cash flows from Year 2 to Year 20, at time T = 2: PMT*(1-(1+r)^-n)/r = 111,000,000*(1-(1+11%)^-19)/11% = 870,161,657

PV of this value at T = 0: 870,161,657/(1+11%)^1 = 783,929,421

NPV at T = 0: -620,000,000 + 783,929,421 = 163,929,421

a-2). Since oil wells project has higher NPV than the aluminum smelter project, the oil wells project should be invested in.

b-1). NPV of Oil wells with r = 11% + 4% = 15%:

PV of cash flows from Year 11 to Year 20, at time T = 10: PMT*(1-(1+r)^-n)/r = 260,000,000*(1-(1+15%)^-10)/15% = 260,000,000*5.0190 = 1,304,940,000

PV of this value at T= 0: 1,304,940,000*(1/(1+15%)^10) = 1,304,940,000*0.247 = 322,320,180

PV of cash flows from Year 5 to Year 10, at time T = 5: PMT*(1-(1+r)^-n)/r = 124,000,000*(1-(1+15%)^-6)/15% = 124,000,000*3.784 = 469,216,000

PV of this value at T = 0: 469,216,000/(1+15%)^4 = 469,216,000*0.572 = 268,391,552

NPV at T = 0: -620,000,000 + 322,320,180 + 268,391,552 = -29,288,268

b-2). Yes, the investment decision will change now as NPV of oil wells project becomes negative.