AsifCo has natural gas fields located in several counties in rural Oklahoma. Asi

Question

AsifCo has natural gas fields located in several counties in rural Oklahoma. AsifCo has two proposals for removing the natural gas, each costing $10 million for all associated costs including drilling equipment, labor, and transportation to the market. In Plan A, all the natural gas will be extracted within one year generating an expected year end cash flow of $12 million. Plan B takes longer to extract the gas and generates cash flows of $1,750,000 per year for the next 20 years. AsifCo has a hurdle rate of 12%. Which way should AsifCo go and why?

*You will need to answer the question as if you were providing advice to senior management. I expect a short paragraph clearly stating your recommendation/results and how you reached the conclusion.  

Explanation / Answer

First of all we will need to evaluate the NPV of each Plan

NPV of Plan A = -10,000,000 + 12,000,000/(1+0.12) = -10,000,000 + 10,714,286 =$714,286

NPV of Plan B = -10,000,000 + 1,750,000 x {(1-(1+0.12)-20)/0.12}

= -10,000,000 + 1,750,000 x 7.4694

= -10,000,000 + 13,071,526

= $3,071,526

Out of the two evaluated options, the NPV of Plan-B is higher than Plan-A, so Plan-B should be chosen. This is because it is resulting into higher value addition in the company over the project life. Moreover, since Plan-B is spread over 20 years of operations, it will help company sustain in market for longer duration through better planning/utilization of resources. Hence, Plan-B is the suitable option.

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