Northern Petroleum is considering two capital projects. The first project, viewed as a high-risk investment, is drilling equipment for oil exploration activities. Northern expects the drilling equipment to cost $1,185,000 and result in operating cash flows before taxes of $448,000 per year for five years. The drilling equipment has a five-year life and a terminal disposal price of zero.
The second project, viewed as a low-risk investment, is for production equipment that will improve the yield in Northern's refinery. Northern expects the production equipment to cost
$850,000 and result in operating cash flows before taxes of $355,000 per year for four years. The equipment has a four-year life and a terminal disposal price of zero. Northern's income tax rate is 30%. The production and drilling equipment capital cost allowance rate is 25%, declining balance.
1. Which project has the higher net present value if Northern uses an after-tax required rate of return (RRR) of 12% for both projects?
2. A manager at Northern objects to the calculations in requirement 1, arguing that riskier investments should have a higher RRR. Suppose Northern requires an 18% after-tax RRR for high-risk investments and a 12% after-tax RRR for low-risk investments. Which proj ect has the higher net present value?
3. Which project do you favour? Why?