1) The Ewert Exploration Company is considering two mutually exclusive plans forextracting oil on property for which it has mineral rights. Both plans call for theexpenditure of $10 million to drill development wells. Under Plan A, all the oil will beextracted in 1 year, producing a cash flow at t = 1 of $12 million; under Plan B, cash flowswill be $1.75 million per year for 20 years.
a. What are the annual incremental cash flows that will be available to Ewert Explorationif it undertakes Plan B rather than Plan A? (Hint: Subtract Plan A’s flows from B’s.)
b. If the company accepts Plan A and then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows fromreinvestment to equal the cash flows from Plan B?
c. Suppose a firm’s cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10%, because the entire firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project’s cash flows?
d. Construct NPV profiles for Plans A and B, identify each project ’ s IRR, and indicatethe crossover rate.
2) The Pinkerton Publishing Company is considering two mutually exclusive expansionplans. Plan A calls for the expenditure of $50 million on a large-scale, integrated plant thatwill provide an expected cash flow stream of $8 million per year for 20 years. Plan B callsfor the expenditure of $15 million to build a somewhat less efficient, more labor-intensiveplant that has an expected cash flow stream of $3.4 million per year for 20 years. Thefirm ’ s cost of capital is 10%.
a. Calculate each project ’ s NPV and IRR.
b. Set up a Project ? by showing the cash flows that will exist if the firm goes with the large plant rather than the smaller plant. What are the NPV and the IRR for this Project ??
c. Graph the NPV profiles for Plan A, Plan B, and Project ? .
3) Shao Airlines is considering the purchase of two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $30million per year. Plane B has a life of 10 years, will cost $132 million, and will produce net cash flows of $25 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company’s cost of capital is 12%. By how much would the value of the company increase if it accepted the better project (plane)? What is the equivalent annual annuity for each plane?