Capital Budgeting Case

Profit Oil Company, INC.

Background:

Petroleum Rig Operations Financed in Texas Inc, henceforth referred to as PROFIT is a regional oil exploration company headquartered in the Houston, TX. It is a conservative rationalized corporation solely owned and operated by the Johnnie Walker (JW) Harrison. He goes by JW to avoid focusing on his given name in the social settings. JW has been in the oil extraction business for over 25 years and has seen both good times and bad.

JW did 2012 extensive geotechnical and seismic testing at a cost of $2,000,000 in a newly opened lease area in Gulf of Mexico. He would have acquired these costs whether or not he proceeded with the project. These evaluations indicated, but didn’t guarantee, that a drilling venture in this area could be successful. He is extremely strong on the engineering side of the oil business but desperately requires your financial acumen to advise him with this substantial investment compensating him for his wildcat reputation.

Facts & Data:

The extraction time (project life) when oil can no longer be economically recovered is estimated to be ten (10) years. Capital investment costs, revenues, and expenses, are significant and consist of the subsequent:

• Purchase of a jack-up oil rig able of standing 325ft of water and costing $29,500,000. A jack-up rig is a kind of mobile offshore oil and gas drilling platform which is moored on sea floor resting on a number of supporting legs. Most popular design uses 3 legs and can drill to depths of 25,000ft.

• Significant relocation costs of the rig from Costa Rica estimated $2,000,000

• Equipment necessary to bring to full operational status will be $2,500,000

• Tugs, helicopter, equipment, facilities for JW’s use estimated to be $1,000,000

• All of these assets will be fully depreciated on straight line basis over project life. However, JW expects that he will be capable to sell the rig for $7,500,000 in Year 10. There might be cash flow impact in year 10 due to the tax impact associated with the sale.

• Estimated that rig will make 1,000 barrels of oil/day and be in operation 325days

• Locked in a fixed sale price/barrel for 10yrs at $95/barrel

• Estimates the projects variable cost will be 35% of his yearly gross revenues

• Fixed Costs will be $7,500,000 per year. Corporate tax estimated to be 35%

Investment Criteria Established by Profit

• Internal Rate of Return (IRR) greater than his cost of capital which is 22%

• Positive Net Present Value (NPV) discounted at his cost of the capital

• Maximum payback of no more than the 5 years

JW needs answers to the subsequent problems based upon date and info given

1. What are his total investment costs in year 0 which will be capitalized and fully depreciated over 10 year drilling period?

2. What are the yearly cash flows associated with this ambitious venture for years 1-10.

3. What are projects approximate Payback?

4. What is Internal Rate of Return of the project?

5. What is Net Present Value of the project?

6. What is your suggestion to JW as to whether or not this project is viable financially and meets his investment criteria?

These answers constitute the “BASE-LINE” conclusions and suggestion

Do one change at a time and show your results for each. (Total investment costs, cash flows years 1-10, IRR, NPV, PB)

• A drop of 30 drilling days in operation for potential hurricane exposure

• An increase in variable cost percentage to 40% of Revenues

• A decrease in fixed costs by 10% ($750,000)

• An increase in sale price/barrel by 10% ($105)

• A change in his cost of capital to 25% to reflect potential risk increases

1) What is your base line recommendation to JW?

2) What are your suggestion to JW’s problems based upon these individual changes and where would you focus your analysis and why?

3) If you adjusted for ALL the changes in assumptions (Scenario analysis) above what would your results indicate? How would you advise JW?

IE: Make a grid summary of your conclusions on one page describeing impact on each change (Sensitivity Analysis) on the investment criteria established by JW.

If you adjusted for ALL the changes in assumptions (Scenario analysis) above what would your results indicate? How would you recommend JW?