Assignment:
NPV Analysis
A natural gas energy company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan D, all the natural gas would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan E, cash flows would be $2.1 million per year for 20 years. The firm's WACC is 13%.
a. Construct NPV profiles for Plans D and E, identify each project's IRR, and show the approximate crossover rate.
b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 13%? If all available projects with returns greater than 13% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 13% because all the company can do with these cash flows is to replace money that has a cost of 13%? Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows?