Fundamentals of Financial Manageme...
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Fundamentals of Financial Manageme...
NPV PROFILES: TIMING DIFFERENCES An oil-drilling company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan B, cash flows would be $2.1 million per year for 20 years. The firm’s WACC is 12%.
- a. Construct NPV profiles for Plans A and B, identify each project’s IRR, and show the approximate crossover rate.
- b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 12%? If all available projects with returns greater than 12% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 12% because all the company can do with these cash flows is to replace money that has a cost of 12%? Does this imply that the WACC is the correct reinvestment rate assumption for a project’s cash flows? Why or why not?
a.
To prepare: NPV profiles for Plan A and B, IRR of the two plans and approximate crossover rate and IRR of each plan.
Introduction:
Net Present Value (NPV):
It is a method under capital budgeting which includes the calculation of net present value of the project in which the company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after considering the discounted rate.
Internal Rate of Return (IRR):
It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital.
Crossover Rate:
It refers to the discounted rate at which the NPV of the two projects becomes equal. It is a cost of capital of the project.
Given information:
The cost of Plan A is $12 million.
Life of the project under Plan A is 1 year.
Cash inflow per year under Plan A is $14.4 million.
The cost of Plan B is $12 million.
Life of the project under Plan B is 20 years.
Cash inflow per year under Plan B is $2.1 million.
The cost of capital of the two plans is 12%.
The NVP profile and crossover rate for the Plan A and B is:
Fig.1
The IRR of the Plan A on spreadsheet is:
b.
To explain: Whether it is logical for a firm to accept all the projects with returns greater than 12% WACC and whether this implies that the WACC is the correct reinvestment rate of assumption for the project cash flows.
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