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