The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which

it has mineral rights. Both plans call for the expenditure of $10,000,000 to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t _ 1 of $12,000,000, while under Plan B, cash flows will be $1,750,000 per year for 20 years. a. What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B rather than Plan A? (Hint: Subtract Plan As flows from Bs.) b. If the firm accepts Plan A, then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B? c. Suppose a company has a cost of capital of 10 percent. Is it logical to assume that it would take on all available independent projects (of average risk) with returns greater than 10 percent? Further, if all available projects with returns greater than 10 percent have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10 percent, because all the firm could do with these cash flows would be to replace money that has a cost of 10 percent? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a projects cash flows? d. Construct NPV profiles for Plans A and B, identify each projects IRR, and indicate the crossover rate of return. SOLUTION a. Year 0 1 2-20 Plan B ($10,000,000) 1,750,000 1,750,000 Incremental Cash Plan A ($10,000,000) 12,000,000 0 Flow (B - A) $ 0 1,750,000

(10,250,000)

If the firm goes with Plan B, it will forgo $10,250,000 in Year 1, but will receive $1,750,000 per year in Years 2-20.

b. If the firm could invest the incremental $10,250,000 at a return of 16.07%, it would receive cash flows of $1,750,000. If we set up an amortization schedule, we would find that payments of $1,750,000 per year for 19 years would amortize a loan of $10,250,000 at 16.0665%. Financial calculator solution: Inputs 19
N I

-10250000
PV

1750000
PMT

0
FV

Output

= 16.0665

c. Yes, assuming (1) equal risk among projects, and (2) that the cost of capital is a constant and does not vary with the amount of capital raised. d. See graph. If the cost of capital is less than 16.07%, then Plan B should be
N P V (M illions of D olla rs)
25

20

15

10

C rossover R ate = 16.07%

A
5

I R RB = 1 6 . 7 % I R RA = 2 0 %

10

15

20

25

C o st of C apital (% )

accepted; if r > 16.07%, then Plan A is preferred.