A task force of capital budgeting analysts at Morrison Ltd. collected the following data concerning the drilling and production of known petroleum reserves at an offshore location:
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Investment in rigging equipment and related personnel costs required to pump the oil
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$
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7,000,000
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Net increase in inventory and receivables associated with the drilling and production of the reserves. Assume this investment will be recovered at the end of the project
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1,270,000
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Net cash inflow from operations for the expected life of the reserves, by year:
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2016
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2,070,000
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2017
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3,670,000
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2018
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1,770,000
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Salvage value of machinery and equipment at the end of the well's productive life
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1,070,000
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Cost of capital
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8
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%
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Required:
a. 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 2016, and the net cash inflows from operations will be received in a lump sum at the end of each year (Ignore income taxes).
b. What will the internal rate of return on this investment be relative to the cost of capital?