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An oil-drilling company must choose between two mutually exclusive extraction projects, and each requires an initial outlay at t = 0 of $12.4 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.88 million. Under Plan B, cash flows would be $2.2034 million per year for 20 years. The firm's WACC is 12.3%.

Answer :

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Answer:

                     PLAN A

Year Cashflow DF@12.3           PV

             

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m                $

0          (12.4)         1          (12.4)

1           14.88      0.8905          13.25

          NPV                 0.85

                   PLAN B

Year Cashflow DF@12.3    PV                              

                   

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m                                

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m

0          (12.4)          1    (12.4)

1-20  2.2034      7.3309  16.15

          NPV           3.75

Project B should be accepted

Explanation:

In this case, we need to discount the cash inflow of plan A at 12.3% for 1 year and then deduct the initial outlay from the present value of cash inflow. The discount factor could be derived from the present value table.

For plan B, we will discount the cash inflow at 12.3% for 20 years. In this case, we will use the annuity factor for 20 years.  Thereafter, we will multiply the cashflow by the annuity factor for 20 years to obtain the present value. The initial outlay will be deducted from the present value so as to obtain the net present value(NPV).

The annuity factor can be obtained from the present value of annuity table.

The project with the higher NPV will be accepted.

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