Question

Question No. 2: a) Imagine you have been hired by Enormous Oil, Inc (EOI). They ask you to evaluate a project. After getting estimates from the engineers you determine that the project will have an initial capital cost of $10 million to implement and yield 100,000 barrels of oil per year. Based on this information ALONE do you have enough information to recommend investing in the project. If not, please describe the information that you lack regarding the viability of the project. b) Now imagine that the engineer tells you that the project will produce 100,000 barrels of oil each year for 10 years and he expects oil will cost $50/barrel over this period. Does this change the conclusion you reached in repose to subpart (a)? c) Assume that the engineer tells you that the project will also generate operating expenses of $100,000 per year. You may assume that since this oil is located in The People's Democratic Republic of Masonistan there are no taxes. How would this information change the conclusions you reached in subpart (a). d) Assume that the President of EOI informs you that their hurdle rate (discount rate) has increased to 15%. Does this impact your conclusions? e) Determine the hurdle rate at which this project would just break even.

Answer 1

Answer:

(a) Information is grossly insufficient. First, unless price per barrel is not known, revenue in terms of dollars cannot be computed and net benefit cannot be calculated. Second, if a discount rate is not available, any cash flow analsysis will be inaccurate because that would ignore time value of money. (b) Annual revenue = 100,000 x $50 = $5,000,000 We still don't have any discount rate. But we can perform a rough analysis by ignoring inflation and other time value effects as follows: Net present value (NPV) of project = - $10,000,000 + (10 x $5,000,000) = - $10,000,000 + $50,000,000 = $40,000,000 Since undiscounted NPV > 0, the project can be undertaken. (c) Net annual revenue = Revenue - cost = $(5,000,000 - 100,000) = $4,900,000 Net present value (NPV) of project = - $10,000,000 + (10 x $4,900,000) = - $10,000,000+ $49,000,000 = $39,000,000 Since undiscounted NPV > 0, the project can be undertaken.