Question: An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan A, all the oil would be

An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan B, cash flows would be $2.1 million per year for 20 years. The firm’s WACC is 12%.

a. Construct NPV profiles for Plans A and B, identify each project’s IRR, and show the approximate crossover rate.

b. Is it logical to assume that the firm would take on all available independent, average risk projects with returns greater than 12%? If all available projects with returns greater than 12% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 12% because all the company can do with these cash flows is to replace money that has a cost of 12%? Does this imply that the WACC is the correct reinvestment rate assumption for a project’s cash flows?

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