ConocoPhillips’s (COP) Natural Gas and Gas Products Department (NG&GP) manages all of the company’s activities relating to the gathering, purchasing, processing, and sale of natural gas and gas liquids. Chris Simpkins, a recent graduate, was recently hired as a financial analyst to support the NG&GP department. One of Chris’s first assignments was to review the projections for a proposed gas purchase project that were made by one of the firm’s field engineers. The cash flow projections for the ten-year project are found in Exhibit P3-12.1 and are based on the following assumptions and projections: The investment required for the project consists of two components: First, there is the cost to lay the natural gas pipeline of $1,200,000. The project is expected to have a ten-year life and is depreciated over seven years using a seven-year modified accelerated cost recovery system (MACRS).20 Second, the project will require a $145,000 increase in net working capital that is assumed to be recovered at the termination of the project. 20 Modified accelerated cost recovery system (MACRS) uses a shorter depreciable life for assets, thus giving businesses larger tax deductions and cash flows in the earlier years of the project life relative to those of straight-line depreciation. The well is expected to produce 900,000 cubic feet (900 MCF) per day of natural gas during year 1 and then decline over the remaining nine-year period (365 operating days per year). The natural gas production is expected to decline at a rate of 20% per year after year 1. In addition to the initial expenditures for the pipeline and additional working capital, two more sets of expenses will be incurred. First, a fee consisting of 50% of the wellhead natural gas market price must be paid to the producer. In other words, if the wellhead market price is $6.00 per MCF, 50% (or $3.00 per MCF) is paid to the producer. Second, gas processing and compression costs of $0.65 per MCF will be incurred. There is no salvage value for the equipment at the end of the natural gas lease. The natural gas price at the wellhead is currently $6.00 per MCF. The cost of capital for this project is 15%.

Part A: What are the NPV and IRR for the proposed project, based on the forecasts made above?

Should Chris recommend that the project be undertaken? Yes or No? Explain your answer.

What reservations, if any, should Chris have about recommending the project to his boss?

Part B: Perform a SCENARIO (NOT sensitivity as indicated in the text) analysis of the proposed project to determine the impact on NPV and IRR for each of the following scenarios:

Best case: a natural gas price of $8.00 and a year 1 production rate of 1,200 MCF per day that declines by 20% per year after that.

Most likely case: a natural gas price of $6.00 and a year 1 production rate of 900 MCF per day that declines by 20% per year after that.

Worst case: a natural gas price of $3.00 and a year 1 production rate of 700 MCF per day that declines by 20% per year after that.

Part C. Do breakeven sensitivity analysis to find each of the following:

Breakeven natural gas price for an NPV = 0

Breakeven natural gas volume in year 1 for an NPV = 0

Breakeven investment for an NPV = 0

Given the results of your risk analysis in parts b and c, would you recommend this project? Explain your answer.