Question #13406

the abc big oil 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 $10mm to drill development wells. under plan a, all the oil will be extracted in 1 year, producing a cash flow at t=1 of $12mm, while plan b would have cash flows of $1.75mm per year for 20 years.
a) What are the annual incremental cash flows that will be available to the firm if it undertakes Plan B rather than Plan A?
b) If the firm 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 of Plan B?

Expert's answer

A) Incremental cash flows, in comparing two alternatives, are the net amounts by which the firm is better / worse off each year by choosing one alternative over another. If I pick a project X that pays me 100 the first year, and 50 the second year, and thereby forgo some project Y that would have given me 40 in each of the next 3 years, my incremental CFs are +60, +10, -40. Note that if I choose Y over X, the inc. CFs of that choice are -60, -10, +40.

B) What is the Year 1 incremental cash of choosing oil-extraction method A over B? Next, what are the 19 incremental CFs in years 2 - 20 of choosing B over A? Note that these 19 B-over-A incremental CFs form a 19-year annuity in years 2 - 20. Finally, what discount rate causes that 19-year annuity to have a present value that's equal to the Year 1 A-over-B incremental CF? (Finding the correct discount rate is usually a trial-and-error exercise, unless you use a tool such as Excel, or a financial calculator.)

B) What is the Year 1 incremental cash of choosing oil-extraction method A over B? Next, what are the 19 incremental CFs in years 2 - 20 of choosing B over A? Note that these 19 B-over-A incremental CFs form a 19-year annuity in years 2 - 20. Finally, what discount rate causes that 19-year annuity to have a present value that's equal to the Year 1 A-over-B incremental CF? (Finding the correct discount rate is usually a trial-and-error exercise, unless you use a tool such as Excel, or a financial calculator.)

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