The Ewert Exploration Company is considering two mutually exclusive plans for ex
ID: 2640238 • Letter: T
Question
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 $9.5 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 $10.5 million; under Plan B, cash flows will be $1.4 million per year for 20 years.
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.)
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.
%
Explanation / Answer
a. Incremental Cash
Year Plan B Plan A Flow (B - A)
0 ($9,500,000) ($9,500,000) $ 0
1 1,400,000 10,500,000 (9,100,000)
2-20 1,400,000 0 1,400,000
If the firm goes with Plan B, it will forgo $9,100,000 in Year 1, but will receive $1,400,000 per year in Years 2-20.
b. If the firm could invest the incremental $9,100,000 at a return of 16.07%, it would receive cash flows of $1,400,000. If we set up an amortization schedule, we would find that payments of $1,400,000 per year for 19 years would amortize a loan of $9,100,000 at 14.14%.
N=19, PV= -9,100,000 PMT=1,400,000 FV=0 I=?
Output=14.14
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