Depoil Plc is an oil company in Ozonland that has been extremely profitable over the last 50 years. During that period the company has accumulated very large cash reserves.
The level of oil extraction from Depoil Plc’s wells has been declining steadily over the last few years. In response, the board is currently considering two mutually exclusive options.
The first option is to undertake a project that will require Depoil Plc to invest in new technology that will allow it to exploit a different form of energy. The first phase of the project will take 5 years during which time it is forecast that the revenues will be relatively low and the costs comparatively high.
18 months ago Depoil Plc obtained an exploratory report (‘Exploratory Report’) on geological conditions of the land it owns and may decide to mine. The Exploratory Report cost £5 million. Depoil Plc got the Exploratory Report simply because it wanted to know more about the land it owned and would have obtained it irrespective of whether it pursues Option 1, Option 2 or does nothing at all.
In order to assess the early phase of proposed Option 1 project, the company has commissioned a report to evaluate the project’s net present value (‘Evaluation Report’) on the basis of a nominal after-tax cost of capital of 12%. The Evaluation Report will immediately cost £3 million.
1. The Board of Depoil Plc are going to make a decision about which option to take on the basis of maximizing net present value (‘NPV’). Discuss why it makes sense for the Board to make its decision on the basis of NPV rather than on the basis of profit maximization. [6 marks]
2. In regards to Part B, Option 1:
(a) Calculate the cash flows and the nominal after-tax Net Present Value for Option One using the after-tax cost of capital of 12%. [30 marks]
Marks will be awarded for both the calculation of Net Present Value and the workings in respect of each of the cash flows relevant to Option One, which show how you arrived at the figures used in calculating Net Present Value.
(b) Discuss the financial acceptability of Option One for Depoil Plc. [4 marks]
3. The government is facing pressure from Depoil Plc to provide subsidies on Option Two as well as Option One.
The government intends to make a decision on this issue by comparing the NPV of the two different options. It has asked Depoil Plc to provide it with a report comparing the NPV of the two options assuming no government subsidies are available for Option One.
Comment on the government’s intention to use Net Present Value calculated on the basis of Depoil Plc’s cost of funds and not a social discount rate, which takes into account social and political risks, in order to evaluate whether it should subsidize either Option 1 or Option 2. [10 marks]
Please round your figures to the nearest £1,000
Please explain any assumptions you make in giving your answers to the questions in Part B.