QUESTION FOUR $(2)$

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 K$10,000,000$ to drill development wells. Under Plan A$,$ all the oil will be extracted in $1$ year, producing a cash flow at t $=1$ of K$12,000,000,$ while under Plan B$,$ cash flows will be K$1,750,000$ per year for $20$ years.

$($a$)$ What are the annual incremental cash flows that will be available to Ewert Exploration if undertakes Plan B rather than Plan A$?($Hint: Subtract Plan A$$s flows from B$$s$.)$

$($b$)$ If the firm accepts Plan A$,$ 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$?$

$($c$)$ Suppose a company has a cost of capital of $10$ percent. Is it logical to assume that it would take on all available independent projects $($of average risk$)$ with returns greater than $10$ percent? Further, if all available projects with returns greater than $10$ percent have been taken, would this mean that cash flows from past investments would have an opportunity cost of only $10$ percent, because all the firm could do with these cash flows would be to replace money that has a cost of $10$ percent?

Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project$$s cash flows?

$($d$)$ Construct NPV profiles for Plans A and B$,$ identify each project$$s IRR, and indicate the crossover rate of return.