Question 13-9

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on the property for
which it has mineral rights. Both plans call for the expenditure of $10 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 $12 million; under Plan B, cash flows will be
$1.75 million per year for 20 years.
a. 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.)
b. 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?

c. Suppose a firm’s cost of capital is 10%. Is it logical to assume that the firm would take on all available
independent projects (of average risk) with returns greater than 10%? Further, if all available projects with
returns greater than 10% have been taken, would this mean that cash flows from past investments would have
an opportunity cost of only 10%, because all the firm could do with these cash flows would be to replace
money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for
the reinvestment of a project’s cash flows?

d. Construct NPV profile for plans A and B, identify each project’s IRR, and indicate the crossover rate of
return.
Solution:

a.
Year Plan A Plan B Incremental CF

0 (10,000,000) (10,000,000) 0

1 12,000,000 1,750,000 (10,250,000)

2 1,750,000 1,750,000

3 1,750,000 1,750,000

4 1,750,000 1,750,000

5 1,750,000 1,750,000

6 1,750,000 1,750,000

7 1,750,000 1,750,000

8 1,750,000 1,750,000

9 1,750,000 1,750,000

10 1,750,000 1,750,000

11 1,750,000 1,750,000

12 1,750,000 1,750,000

13 1,750,000 1,750,000

14 1,750,000 1,750,000

15 1,750,000 1,750,000

16 1,750,000 1,750,000
 17 1,750,000 1,750,000

18 1,750,000 1,750,000

19 1,750,000 1,750,000

20 1,750,000 1,750,000

Going with Plan B will lead the firm to forego $10,250,000 in first year and will receive $1,750,000 / year in next
nineteen years (From year 2~20)
b.

Initial Investment = I = 10250000

Annual Inflow = A = 1750000
Years = n = 19
Rate = r = 0.1

NPV = A*(1-(1+r)^-n)/r - IP
NPV = 1750000 x (1-(1+0.1)^-19)/0.1 - 10250000
NPV = $4388610.2

r = 15%
NPV = A*(1-(1+r)^-n)/r - IP
NPV = 1750000 x (1-(1+0.15)^-19)/0.15 - 10250000
NPV = $596904.6

r = 16%
NPV = A*(1-(1+r)^-n)/r - IP
NPV = 1750000 x (1-(1+0.16)^-19)/0.16 - 10250000
NPV = $35547

r = 16.07%
NPV = A*(1-(1+r)^-n)/r - IP
NPV = 1750000 x (1-(1+0.1607)^-19)/0.1607 - 10250000
NPV = 0

Reinvesting the incremental $10,250,000 at a return of 16.07% would return cash flows of $1,750,000 /
year for the next 19 years

c.

I believe it's logical given that there's equal risk among all projects and cost of capital does not change with the amount of capi
Definitely the amount can be reinvested in another project having more return than cost of capital however taking cost of capit
reinvstment ensures that firm can at the least gate this return through reinvestment. Thus it is correct reinvestment rate.

d.

RATE VS NPV TABLE

NPV = A*(1-(1+r)^-n)/r - I
Rate Plan A Plan B
5% 1,428,571 11,808,868
6%
7%
 8%
9%
10% 909,091 4,898,737
11%
12%
13%
14%
15% 434,783 953,830
16% 344,828 375,472
17% 256,410 (151,407)
18% 169,492 (632,694)
19% 84,034 (1,073,491)
20% - (1,478,235)

RATE VS NPV
14,000,000 PLAN B

12,000,000

10,000,000 CROSS OVER

RATE = 16.07%
8,000,000

6,000,000

4,000,000 PLAN A

2,000,000

-
4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
(2,000,000) PLAN A
PLAN B
IRR = 20%
IRR = 16.7%
(4,000,000)

Question 13-20
The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the
expenditure of $50 million on a large-scale, integrated plant that will provide an expected cash flow stream of $8
million per year for 20 years. Plan B calls for the expenditure of $15 million to build a somewhat less efficient, more
labor-intensive plant that has an expected cash flow stream of $3.4 million per year for 20 years. The firm's cost of
capital is 10%.
a. Calculate each project's NPV and IRR
b. Set up a Project  by showing the cash flow that will exist if the firm goes with the large plant rather than the
smaller plant. What are the NPV and the IRR for this project ?
c. Graph the NPV profiles for Plan A, Plan B, and Project 
d. Give a logical explanation, based on reinvestment rates and opportunity costs, as to why the NPV method is
better than the IRR method when the firm’s cost of capital is constant at some value such as 10 percent.

a,b)
Year Plan A Plan B Project 
 0 -50000000 -15000000 -35000000
1 8000000 3400000 4600000
2 8000000 3400000 4600000
3 8000000 3400000 4600000
4 8000000 3400000 4600000
5 8000000 3400000 4600000
6 8000000 3400000 4600000
7 8000000 3400000 4600000
8 8000000 3400000 4600000
9 8000000 3400000 4600000
10 8000000 3400000 4600000
11 8000000 3400000 4600000
12 8000000 3400000 4600000
13 8000000 3400000 4600000
14 8000000 3400000 4600000
15 8000000 3400000 4600000
16 8000000 3400000 4600000
17 8000000 3400000 4600000
18 8000000 3400000 4600000
19 8000000 3400000 4600000
20 8000000 3400000 4600000

NPV = A*(1-(1+r)^-n)/r - I 18,108,5 13,946,1 4,162,3

= 10 17 93
IRR = 15.03% 22.26% 11.71%

c. RATE VS NPV TABLE

NPV = A*(1-(1+r)^-n)/r - I
Rate Plan A Plan B Project 
49,697,6 27,371,5 22,326,1
5%
83 15 68
41,759,3 23,997,7 17,761,6
6%
70 32 38
34,752,1 21,019,6 13,732,4
7%
14 48 66
28,545,1 18,381,7 10,163,4
8%
79 01 78
23,028,3 16,037,0 6,991,3
9%
65 55 10
18,108,5 13,946,1 4,162,3
10%
10 17 93
13,706,6 12,075,3 1,631,3
11%
25 16 09
9,755,5 10,396,1 (640,5
12%
49 08 59)
6,198,0 8,884,1 (2,686,1
13%
13 55 43)
2,985,0 7,518,6 (4,533,5
14%
44 44 99)
74,6 6,281,7 (6,207,0
15%
52 27 75)
(2,569,2 5,158,0 (7,727,3
16%
73) 59 32)
(4,977,8 4,134,4 (9,112,2
17%
61) 09 70)
(7,178,0 3,199,3 (10,377,3
18%
28) 38 66)
 (9,193,1 2,342,9 (11,536,0
19%
03) 31 34)
(11,043,3 1,556,5 (12,599,9
20%
62) 71 33)
(12,746,4 832,7 (13,579,2
21%
73) 49 22)
(14,317,8 164,9 (14,482,7
22%
71) 05 76)
(15,771,0 (452,7 (15,318,3
23%
73) 06) 67)

RATE VS NPV
PLAN A
60,000,000

CROSS OVER
50,000,000
RATE = 11.7%
PLAN B
40,000,000

30,000,000
PLAN A
20,000,000 IRR = 15%
PROJECT 
10,000,000

-
4% 6% 8% 10% 12% 11.7
14% 16% 18% 20% 22% 24%
%
(10,000,000)
PLAN B
(20,000,000) IRR = 22.26%

d.
The NPV method assumes that the opportunity exists to reinvest the cash flows generated by a project at the required
rate of return, whereas use of the IRR method implies the oportunity to reinvest at the IRR. All independent projects
with NPV greater than 0 should be selected by the firm. As cash flows come in from these projects, the firm will either
pay them out to investors, or use them as a substitute for outsidefunds that, in this case, costs 10%. Thus, because
these cash flows are expected to save the firm 10%, this is their opportunity cost reinvestment rate.
The IRR method assumes reinvestment at the internal rate of return itself, which is an incorrect assumption, given a
constant expected future required rate of return.