Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to expand their facilities for supplies and custom drill bit production to meet the increased demand. The expansion will occur over 4 years and is expected to require $2.8 million. Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700,000 one year from now, $800,000 two years from now, and finally, $1,000,000 four years from now. While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project. Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation will meet the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as follows: • Year 1: interest rate of 4.5% p.a. compounded semi-annually . Year 2: interest rate of 5.0% p.a. compounded semi-annually Year 3: interest rate of 5.0% p.a. compounded semi-annually • Year 4: interest rate of 5.5% p.a. compounded semi-annually As an alternative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a period of five years. The company can withdraw part of the money from either investment at any time without penalty to meet the cash payment requirements. 1. Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations 2. What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?
Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to expand their facilities for supplies and custom drill bit production to meet the increased demand. The expansion will occur over 4 years and is expected to require $2.8 million. Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700,000 one year from now, $800,000 two years from now, and finally, $1,000,000 four years from now. While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project. Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation will meet the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as follows: • Year 1: interest rate of 4.5% p.a. compounded semi-annually . Year 2: interest rate of 5.0% p.a. compounded semi-annually Year 3: interest rate of 5.0% p.a. compounded semi-annually • Year 4: interest rate of 5.5% p.a. compounded semi-annually As an alternative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a period of five years. The company can withdraw part of the money from either investment at any time without penalty to meet the cash payment requirements. 1. Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations 2. What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?
Chapter10: Capital Budgeting: Decision Criteria And Real Option
Section: Chapter Questions
Problem 12P
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Transcribed Image Text:Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to
expand their facilities for supplies and custom drill bit production to meet the increased demand.
The expansion will occur over 4 years and is expected to require $2.8 million.
Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700,000 one year from now,
$800,000 two years from now, and finally, $1,000,000 four years from now.
While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns
or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project.
Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation willmeet
the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as
follows:
• Year 1: interest rate of 4.5% p.a. compounded semi-annually
• Year 2: interest rate of 5.0% p.a. compounded semi-annually
• Year 3: interest rate of 5.0% p.a. compounded semi-annually
Year 4: interest rate of 5.5% p.a. compounded semi-annually
As an altemative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a
period of five years.
The company can withdraw part of the money from eitherinvestment at any time without penalty to meet the cash payment requirements.
1. Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date.
Show your calculations
2. What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the
expansion?
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