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 $10.5 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t= 1 of $13.5 million; under Plan B, cash flows will be $2 million 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.) Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places. Use a minus sign to enter cash outflows, if any. Year Incremental Cash Flow (B-A) million $ $ million 2-20 b. If the company accepts Plan A and 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? Round your answer to two decimal places. c. Suppose a firm's cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10% because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows? I. Yes, assuming unequal risk among projects, and that the cost of capital is a constant and does t vary with the amount of capital raised. II. Yes, assuming equal risk among projects, and that the cost of capital decreases with the amount of capital raised. III. Yes, assuming equal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised.
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 $10.5 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t= 1 of $13.5 million; under Plan B, cash flows will be $2 million 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.) Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places. Use a minus sign to enter cash outflows, if any. Year Incremental Cash Flow (B-A) million $ $ million 2-20 b. If the company accepts Plan A and 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? Round your answer to two decimal places. c. Suppose a firm's cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10% because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows? I. Yes, assuming unequal risk among projects, and that the cost of capital is a constant and does t vary with the amount of capital raised. II. Yes, assuming equal risk among projects, and that the cost of capital decreases with the amount of capital raised. III. Yes, assuming equal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
Related questions
Question
100%
Transcribed Image Text: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 $10.5 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t = 1 of $13.5
million; under Plan B, cash flows will be $2 million 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.) Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your
answers to two decimal places. Use a minus sign to enter cash outflows, if any.
Year Incremental Cash Flow (B - A)
1
$
$
million
million
2-20
b. If the company accepts Plan A and 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? Round your answer to two decimal places.
%
c. Suppose a firm's cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from
past investments would have opportunity cost of only 10% because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows?
I. Yes, assuming unequal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised.
II. Yes, assuming equal risk among projects, and that the cost of capital decreases with the amount of capital raised.
III. Yes, assuming equal risk among projects, and that the cost of capital is a constant and does not vary with the amount of capital raised.
-Select- V
d. Select the correct aranh for NRV profiles for Plans A and B
Transcribed Image Text:d. Select the correct graph for NPV profiles for Plans A and B.
%
%
%
ܬ ܬ
NPV Millions of Dollars)
-5
30
25
20
15
H
10
B
The correct graph is -select- V
Identify each project's IRR. Round your answers to two decimal places.
Project A:
Project B:
Indicate the crossover rate. Round your answer to two decimal places.
A
5 10. 15 20
Cost of
capital (%)
-5
30
25
20
15
10-
A
B
B
10
Cost of capital (%)
15
20
-5
30
25
20
15
10-
5
10
15
B
20
25
Cost of capital (%)
-5
30
25
20
15
10-
D
A
2
B
Cost of
[O 15 20 25
capital (%)
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