eBook

Timing Differences

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 million 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 million; under Plan B, cash flows will be $1.75 million per year for 20 years.

1. 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 A's flows from B's.) Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places. Use a minus sign to enter cash outflows, if any.

   Year	Incremental Cash Flow (B - A)
   1	$ million
   2-20	$ million

2. If the company accepts Plan A and 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? Round your answer to two decimal places.

   %

3. Suppose a firm's cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10% because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows?

   I. Yes, assuming unequal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised. II. Yes, assuming equal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised. III. Yes, assuming equal risk among projects, and that the cost of capital decreases with the amount of capital raised.

   -Select-

4. Select the correct graph for NPV profiles for Plans A and B.

   The correct graph is

   Identify each project's IRR. Round your answers to two decimal places.

   Project A: %

   Project B: %

   Indicate the crossover rate. Round your answer to two decimal places.

   %