Problem: Calculate NPV and compare to IRR. The following data have been collected by a task force of capital budgeting analysts at Sam Adams Ltd. Concerning the drilling and production of known reserves at an off-shore location:
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Investment in rigging equipment and related personnel costs
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required to pump the oil
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$4,900,000
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Net increase in inventory and receivables associated with the
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drilling and production of the reserves. Assume this investment
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will be recovered at the end of the project
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$960,000
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Net cash inflow from operations for the expected life of the reserves, by year:
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2006
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$1,600,000
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2007
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$2,880,000
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2008
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$1,360,000
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Salvage value of machinery and equipment at the
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end of the well's productive life
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$800,000
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Cost of Capital
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12%
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Required:
Question 1: Calculate the net present value of the proposed investment in the drilling and production operation. Assume that the investment will be made at the beginning of 2006, and the net cash inflows from operations will be received in lump sum at the end of each year. Ignore income taxes, and round answers to the nearest $1.
Question 2: What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.
Question 3: Differences between estimates made by the task force and actual results would have an effect on the actual rate of return on the project. Identify the significant estimates made by the task force. For each estimate, state the effect on the actual ROI if the estimate turns out to be less than the actual amount finally achieved.