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NPV PROFILES: TIMING DIFFERENCES An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan B, cash flows would be $2.1 million per year for 20 years. The firm's WACC is 12%.
a. Construct NPV profiles for Plans A and B, identify each project's IRR, and show the approximate crossover rate.
b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 12%? If all available projects with returns greater than 12% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 12% because all the company can do with these cash flows is to replace money that has a cost of 12%? Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows?
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