Reference no: EM133715829

Question: Oil exploitation company XYZ plans to exploit a large oil field that the management proudly considers to be imperishable, which will make the company a perpetual legacy. She requested a quote from two major drilling equipment manufacturers to decide what type of equipment to purchase. Manufacturer A offers equipment that costs $12 million and has a lifespan of 4 years. The equipment does not require any maintenance during its operation, but at the end of each year of use it requires repair costs of $6 million otherwise it will not be functional the following year. At the end of the fourth year, if the company carries out the annual repair, it can sell it to a groundwater exploration company for $4M, otherwise it will have no value. Manufacturer B, for its part, offers more sophisticated equipment, which costs $16M with a lifespan of 9 years and requiring maintenance costs whose value at the end of each year of use is $4M . Its resale value is zero at the end of the ninth year. Manufacturers A and B charged fees of $17,000 and $19,000 respectively for the two estimates provided. They also demanded an exclusivity clause in the sense that if company XYZ opts for their equipment, it will always have to renew it with them, under the same conditions, throughout the entire oil exploitation project. Currently, the company is financed 75% by debt at a cost of 10% and 25% by equity at a cost of 30%. She also has a line of credit of 10 million dollars with her bank, at a rate of 8%.

1. Which manufacturer should XYZ company choose? Hint: The two pieces of equipment do not have the same lifespan, it is therefore necessary to calculate and compare their equivalent annual cost (CAE).

2- What is then the present value of the cost of the equipment necessary for the entire lifespan of the oil exploitation project?

3-XYZ forecasts production of 1 million barrels of oil per year. Unit variable cost production is $12 per barrel. The unit selling price is $22. Ignoring tax, what is the present value of future net cash flows (turnover annual minus annual variable cost) throughout the life of the project?

4- Should company XYZ then undertake the exploitation project? (supporting calculation)

5- Now suppose that the managers of company XYZ are convinced that the price of oil will move significantly towards the end of the ninth year of operation.

However, they are not not sure if this variation will be upwards or downwards. On the one hand, several research projects are planned of the exploitation of solar energy in maritime and air transport are underway. There would be 50% chance that this research will be successful, which will result in a drop in the price of a barrel of oil to $15 per barrel. This drop will not affect the possible turnover of the first nine years, but if it turns out that the exploitation of the field is no longer profitable, the company will keeps the option of abandoning his project. On the other hand, if this research is unsuccessful, the scarcity of global oil will cause the price of a barrel to rise to 25S. In this case, the company reserves the right to increase its annual production to 1.5 million barrels by adding a second drilling equipment. The manufacturer of this equipment specified in its initial quote that in this case, it will grant a discount of 30% on the purchase price of the additional equipment necessary for the increase in production.

If the company decides to increase its production, the variable cost production unit will then increase to $20 per barrel. With this new information, what is the net present value of the mining project Should the company undertake the project? If so, what will she have to do in nine years?