(Payback period and NPV calculations) Plato Energy is an oil and gas exploration
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Question
(Payback period and NPV calculations) Plato Energy is an oil and gas exploration and development company located in Farmington, New Mexico. The company drills shallow wells in hopes of finding significant oil and gas deposits. The firm is considering two different drilling opportunities that have very different production potentials. The first is in the Barnett Shale region of central Texas and the other is in the Gulf Coast. The Barnett Shale project requires a much larger initial investment but provides cash flows (if successful) over a much longer period of time than the Gulf Coast opportunity. In addition, the longer life of the Barnet Shale project also results in additional expend tures in year 3 of the project to enhance production throughout the project's 10-year expected life. This expenditure involves pumping either water or CO2 down into the wells in order to increasethe fow of oil and gas from the structure. The expected cash flows for the two projects are as follows: a. What is the payback period for each of the two projects? b. Based on the payback periods, which of the two projects appears to be the best alternative? What are the limitations of the payback period ranking? That is, what does the payback period not consider that is important in determining the value creation potential of these two projects? c. If Plato's management uses a discount rate of 18.3 percent to evaluate the present values of its energy investment projects, what is the NPV of the two pro d. What is your estimate of the value that will be created for Plato by the acceptance of each of these two investments? investments? Data Table a. Given the cash flow information in the table, the payback period of the Barnett Shale project isyears. (Round to two decimal places.) Year Barnett Shale Gulf Coast (5,200,000) 2,080,000 2,080,000 (1,040,000) 2,080,000 1,880,000 1,880,000 1,880,000 850,000 450,000 90,000 S(1,200,000) 825.000 825,000 425,000 110,000 10 PrintDone Enter your answer in the answer box and then click Check Answer.Explanation / Answer
Year
cash flow
Amount to be recovered = intial cash outlow+ annual cash inflow
Year
cash flow
cumulative cash flow
0
-5200000
-5200000
0
1200000
1
2080000
-3120000
1
825000
825000
2
2080000
-1040000
2
825000
375000
3
-1040000
-2080000
3
425000
4
2080000
0
4
110000
5
1880000
6
1880000
Payback period =Year prior to final recovery year + amount to be recovered/annual cash flow
1+(375000/825000)
1.454545
7
1880000
8
850000
9
450000
10
90000
Payback period is year 4 because in which entire investment is recovered
Barnett shell
Gulf coast
a
Payback period in Years
4
1.454545
b-
Golf coast is the best option from payback period point of view. Limitation of pay back period is that it ignores the after wards cash flows. Yes which pay back period ignored is also important for value creation by project because payback period only tells the time required to recover the initial investment and it ignores the profitability or return aspect
c-
Year
cash flow
present value of cash flow = cash flow/(1+r)6n r= 18.3%
Year
cash flow
present value of cash flow = cash flow/(1+r)6n r= 18.3%
0
-5200000
-5200000
0
-1200000
-1200000
1
2080000
1758242
1
825000
697379.5
2
2080000
1486257
2
825000
589500.9
3
-1040000
-628173
3
425000
256705.2
4
2080000
1062000
4
110000
56163.44
5
1880000
811398.4
6
1880000
685882
net present value
sum of present value of cash flow
399749.1
7
1880000
579781.9
8
850000
221585.3
9
450000
99163.04
10
90000
16764.67
net present value
sum of present value of cash flow
892900.6
d-
estimate of value created by acceptance of both of projects
892900.6+399749.1
1292650
Year
cash flow
Amount to be recovered = intial cash outlow+ annual cash inflow
Year
cash flow
cumulative cash flow
0
-5200000
-5200000
0
1200000
1
2080000
-3120000
1
825000
825000
2
2080000
-1040000
2
825000
375000
3
-1040000
-2080000
3
425000
4
2080000
0
4
110000
5
1880000
6
1880000
Payback period =Year prior to final recovery year + amount to be recovered/annual cash flow
1+(375000/825000)
1.454545
7
1880000
8
850000
9
450000
10
90000
Payback period is year 4 because in which entire investment is recovered
Barnett shell
Gulf coast
a
Payback period in Years
4
1.454545
b-
Golf coast is the best option from payback period point of view. Limitation of pay back period is that it ignores the after wards cash flows. Yes which pay back period ignored is also important for value creation by project because payback period only tells the time required to recover the initial investment and it ignores the profitability or return aspect
c-
Year
cash flow
present value of cash flow = cash flow/(1+r)6n r= 18.3%
Year
cash flow
present value of cash flow = cash flow/(1+r)6n r= 18.3%
0
-5200000
-5200000
0
-1200000
-1200000
1
2080000
1758242
1
825000
697379.5
2
2080000
1486257
2
825000
589500.9
3
-1040000
-628173
3
425000
256705.2
4
2080000
1062000
4
110000
56163.44
5
1880000
811398.4
6
1880000
685882
net present value
sum of present value of cash flow
399749.1
7
1880000
579781.9
8
850000
221585.3
9
450000
99163.04
10
90000
16764.67
net present value
sum of present value of cash flow
892900.6
d-
estimate of value created by acceptance of both of projects
892900.6+399749.1
1292650
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