Reference no: EM131764

Capital Budgeting Case

Profit Oil Company, INC.

Background:

Petroleum Rig Operations Financed in Texas Inc, hereafter referred to as PROFIT is a regional oil exploration company headquartered in Houston, TX. It is a conservative well run corporation solely owned and operated by Johnnie Walker (JW) Harrison. He goes by JW to avoid focusing on his given name in social settings. JW has been in the oil extraction business for over 25 years and has seen both good times and bad.

JW completed 2012 extensive geotechnical and seismic testing at a cost of $2,000,000 in a recently opened lease area in the Gulf of Mexico. These evaluations indicated, but did not guarantee, that a drilling venture in this area could be successful. He is very strong on the engineering side of the oil business but desperately needs your financial acumen to advise him with this substantial investment compensating him for his wildcat reputation.

Facts & Data:

The extraction time (project life) when oil can no longer be economically recovered is estimated to be ten (10) years. Capital investment costs, revenues, and expenses, are significant and consist of the following:

• Purchase of a jack-up oil rig capable of standing 325ft of water and costing $29,500,000. A jack-up rig is a type of mobile offshore oil and gas drilling platform that is moored on the sea floor resting on a number of supporting legs. Most popular design uses 3 legs and can drill to depths of 25,000ft.
• Significant relocation costs of the rig from Costa Rica estimated $2,000,000
• Equipment necessary to bring to full operational status will be $2,500,000
• Tugs, helicopter, equipment, facilities for JW's use estimated to be $1,000,000
• All of these assets will be fully depreciated on the straight line basisover the project life. However, JW anticipates that he will be able to sell the rig for $7,500,000 in Year 10. There may be cash flow impact in year 10 due to the tax impact associated with the sale.
• Estimated that rig will produce 1,000 barrels of oil/day and be in operation 325days
• Locked in a fixed sale price/barrel for the 10yrs at $95/barrel
• Estimates the projects variable cost will be 35% of his annual gross revenues
• Fixed Costs will be $7,500,000 per year. Corporate tax estimated to be 35%

Investment Criteria Established by Profit

• Internal Rate of Return(IRR) exceeding his cost of capital which is 22%
• Positive Net Present Value(NPV) discounted at his cost of capital
• Maximum payback of no more than 5 years

JW needs answers to the following questions based upon date and info provided

1. What are his total investment costs in year 0 which will be capitalized and fully depreciated over the 10 year drilling period.

2. What are the annual cash flows associated with this ambitious venture for years 1-10.

3. What is the projects approximate Payback.

4. What is the Internal Rate of Return of the project.

5. What is the Net Present Value of the project.

6. What is your recommendation to JW as to whether or not this project is viable financially and meets his investment criteria?

Do one change at a time and show your results for each. (Total investment costs, cash flows years 1-10, IRR, NPV, PB)

• A drop of 30 drilling days in operation for potential hurricane exposure
• An increase in the variable cost percentage to 40% of Revenues
• A decrease in fixed costs by 10% ($750,000)
• An increase in sale price/barrel by 10% ($105)
• A change in his cost of capital to 25% to reflect potential risk increases

1) What is your base line recommendation to JW?

2) What are your recommendations to JW's questions based upon these individual changes and where would you focus your analysis and why?

3) If you adjusted for ALL the changes in assumptions (Scenario analysis) above what would your results indicate? How would you advise JW.