The Windsor Oil Company is considering the construction of a new refinery that can process 12 million barrels of oil per year for a period of five years. The cost of constructing the refinery is $ 2 billion, and it will be depreciated over five years toward a zero salvage value. The plant can produce either gasoline or jet fuel, and the product can be changed once each year based on the prices of the two products. The refinery can convert the 42 gallons of oil in one per barrel of crude into 90% of this quantity of gasoline, or 70% if jet fuel is produced. The residual can be sold but for no net profit. Windsor’s analysts characterize the distribution of gasoline prices for next year and each of the next five years using a triangular distribution that has a minimum value of $ 1.75 per gallon, a most likely value of $ 2.50, and a maximum of $ 4.00. They characterize the price per gallon of jet fuel using a triangular distribution with a minimum value of $ 2.50 per gallon, a most likely value of $ 3.25, and a maximum value of $ 5.00 a gallon. The price of crude is fixed via forward contracts over the next five years at $ 25 per bar-rel.
Windsor also estimates that the cost of refining is equal to 35% of the selling price of the particular product being produced. Windsor faces a 30% tax rate on its income and uses a cost of capital of 10% to analyze refinery investments. The risk-free rate is 5.5%.
a. What is the NPV of the refinery if it produces only jet fuel (because the revenues under this alternative are higher based on the most likely price)?
b. Construct a simulation model for the refinery, with the triangular distributions ­described above, that makes the price of gasoline and jet fuel random variables. What is the NPV of the refinery investment if the firm selects the higher-valued product to produce, based on the realized prices of gasoline and jet fuel?