# Question

A task force of capital budgeting analysts at Morrison Ltd. collected the following data concerning the drilling and production of known petroleum reserves at an offshore location:

Investment in rigging equipment and related personnel costs

required to pump the oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,700,000

Net increase in inventory and receivables associated with the

drilling and production of the reserves. Assume this investment

will be recovered at the end of the project . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000

Net cash inflow from operations for the expected life of the reserves, by year:

2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000

2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600,000

2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700,000

Salvage value of machinery and equipment at the

end of the well’s productive life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8%

Required:

a. Calculate the net present value of the proposed investment in the drilling and production operation. Assume that the investment will be made at the beginning of 2013, and the net cash inflows from operations will be received in a lump sum at the end of each year. Ignore income taxes, and round answers to the nearest $1.

b. What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

c. Differences between estimates made by the task force and actual results would have an effect on the actual rate of return on the project. Identify the significant estimates made by the task force. For each estimate, state the effect on the actual ROI if the estimate turns out to be less than the actual amount finally achieved.

Investment in rigging equipment and related personnel costs

required to pump the oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,700,000

Net increase in inventory and receivables associated with the

drilling and production of the reserves. Assume this investment

will be recovered at the end of the project . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000

Net cash inflow from operations for the expected life of the reserves, by year:

2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000

2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600,000

2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700,000

Salvage value of machinery and equipment at the

end of the well’s productive life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8%

Required:

a. Calculate the net present value of the proposed investment in the drilling and production operation. Assume that the investment will be made at the beginning of 2013, and the net cash inflows from operations will be received in a lump sum at the end of each year. Ignore income taxes, and round answers to the nearest $1.

b. What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

c. Differences between estimates made by the task force and actual results would have an effect on the actual rate of return on the project. Identify the significant estimates made by the task force. For each estimate, state the effect on the actual ROI if the estimate turns out to be less than the actual amount finally achieved.

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