Reference no: EM131441454

Question: Part I (50%)
Consolidated Oilfield plc is interested in exploring for oil near the west coast of Australia. The Australian government is prepared to grant an exploration license to the company for a five-year period for a fee of £250,000 per annum. The option to acquire the rights must be taken immediately, otherwise another oil company will be granted the rights. However, Consolidated Oilfield is not in a position to commence operations immediately, and exploration of the oilfield will not start until the beginning of the second year. In order to carry out the exploration work, the company will require equipment costing £10,500,000, which will be made by a specialist engineering company. Half of the equipment cost will be payable immediately and half will be paid when the equipment has been built and tested to the satisfaction of Consolidated Oilfield. It is estimated that the second instalment will be paid at the end of the first year. The company commissioned a geological survey of the area and the results suggest that the oilfield will produce relatively small amount of high-quality crude oil. The survey cost £350,000 and is now due for payment.

The assistant to the project accountant has produced the following projected profit and loss accounts (income statements) for the project Years 2-5 when the oilfield is operational.

	Year
		2		3		4		5
	£000	£000	£000	£000	£000	£000	£000	£000
Sales		£7,400		£8,300		£9,800		£5,800
Wages and salaries	£690		£545		£633		£490
Materials and consumables	£400		£390		£310		£270
Licence fee	£500		£250		£250		£250
Overheads	£310		£310		£310		£310
Depreciation	£2,175		£2,175		£2,175		£2,175
Survey cost written off	£350
Interest charges	£540		£540		£540		£540
		£4,965		£4,210		£4,218		£4,035
Profit		£2,435		£4,090		£5,582		£1,765

The following additional information is available:
1. The licence fee charge appearing in the accounts in Year 2 includes a write-off for all the annual fee payable in Year 1. The licence fee is paid to Australian government at the end of each year.
2. The overheads contain an annual charge of £150,000, which represents an apportionment of head office costs. This is based on a standard calculation to ensure that all projects bear a fair share of the central administrative costs of the business. The reminder of the overheads relate directly to the project.
3. The survey costs written off relate to the geological survey already undertaken and due for payment immediately.
4. The new equipment costing £10,500,000 will be sold at the end of the licence period for 1,800,000.
5. The project will require a specialised cutting tool for a brief period at the end of Year 2, which is currently being used by the company on another project. The manager of the other project has estimated that he will have to hire machinery at a cost of £200,000 for the period the cutting tool is on loan.
6. The project will require an investment of £480,000 working capital from the end of the first year to the end of the licence period.
7. The company has a cost of capital of 15 per cent. Inflation can be ignored in the analysis.
8. Consolidated Oilfield has a marginal tax rate of 30 per cent.

Required:
You are project managers at Consolidated Oilfield. You need to evaluate this project and present a report to the company's CEO. In the report, you should do ALL of the following investment appraisal calculations for the project:
1. Payback period
2. Discounted payback period
3. Accounting rate of return (ARR)
4. Net present value (NPV)
5. Internal rate of return (IRR)
Based on the calculation above, the report should present an analysis of advantages and disadvantages of undertaking the project, and recommendations whether the project should be accepted.

Part II (30%)
As it turns out, the sales number produced by the accountant only reflects a particular market condition. The project's statistician estimated that sales of the project could fluctuate widely and produced the following sales table:

	Years	2	3	4	5
		£000	£000	£000	£000
Good		£10,300	£12,000	£15,500	£8,300
Neutral		£7,400	£8,300	£9,800	£5,800
Bad		£4,000	£2,900	£3,100	£2,600

When the market condition is good, the project will generate large sales, much larger than the estimate from the accountant. According to the statistician, the probability for good, neutral and bad market condition are 0.25, 0.25 and 0.50. Assuming all other costs is not affected by the market condition. You should calculate:

1. NPVs when the market condition is good and bad

2. Expected NPV of the project

3. Standard deviation of the project's NPV

4. Calculate the probability that NPV of the project is larger than 0

Based on the above calculations, would you change your recommendations made in Part I, explain reasons of your decision. Finally, the CEO of Consolidated Oilfield plc has informed you that the company currently have another similar project ready for investment, however, funds are only enough for one project. The other project has an expected NPV of £30,000 and standard deviation of NPV is £1,000,000. Advise the CEO (with reasons) which project the company should invest.

Part III (20%)
There are two investments, A and B, which are available for investing. The return and standard deviation of A are 12% and 33%, respectively. The return and standard deviation of B are 9% and 27%, respectively. The correlation between the two investments is -0.3.
Required:
1. Calculate portfolio return and standard deviation when investing 30% of your wealth in A and 70% in B.
2. Calculate portfolio return and standard deviation when investing 50% in A and 50% in B.
3. Calculate portfolio return and standard deviation when investing 70% in A and 30% in B.
4. What is the lowest portfolio standard deviation that can be achieved when you invest in A and B? How much percentage should be invested in A and B to obtain the lowest portfolio standard deviation?

 

Any and all the references to material used must be properly acknowledged and referenced. Whenever you use information from an original source you have to report this source in the text and give full details of it in the reference list. A list of references at the end of your essay is not enough. If you use actual extract from a source, you should place it in speech quotes or use italics. You should use double space formatting of the text.Your report should not be longer than 8 pages A4 side, excluding references and appendices and using font 12 Times New Roman letter type. It should be typed in a Word document and the page setup should be 1' (2.5 cm) margin on all sides. Your ability to summarize and focus on the important issues is also assessed and you should not exceed the set limit.