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SEMESTER Fall 2016 Corporate Finance (FIN722) Assignment No. 1 Due Date: November 29, 2016 Marks: 30
Topic: Capital Budgeting Techniques and Capital Rationing
Learning Objectives: After attempting this assignment, students will be able to:
1) Understand the working of initial outlay by differentiating relevant and irreverent costs.
2) Rank the projects by applying the concept of capital rationing.
Question: An oil and gas drilling company is intending to expand its oil and gas extraction business in different regions of Pakistan. Last year for this purpose, the petroleum geologists of the company had conducted a hydrocarbon exploration survey costing Rs.10 million to search the oil and gas deposits under the earth surface in four regions of Pakistan consisting of North, South, West and East. The company has already acquired exploration and extraction license from the petroleum ministry of Pakistan that costs Rs. 850,000. The company is required to purchase drilling rig (petroleum extraction machine) and build oil and gas wells according to the location requirements of each region. Corporate tax rate is 30%. The company uses straight line method for depreciation purpose. The company has limited capital budget of Rs.12,00,000 and is concerned about the best way to allocate its capital in following projects. All of these projects are independent and divisible but cannot be delayed to next period. Project A: Extraction in South region Project A includes extraction in south offshore region of Pakistan that requires deep water drilling rig costing Rs. 400,000. Drilling rig installation cost is high in deep water due to depth of oil fields that will be 50% of cost of the drilling rig. Cost of building oil well will be Rs.100,000. Other working capital requirements will be Rs. 30,000. The total project life is four years. Years 1 2 3 4 Discounted cash flows (Rs.) 50,000 170,000 290,000 307,600 Project B: Extraction in North region Project B includes extraction in northern region of Pakistan that requires drilling rig of Rs.60,000. Installation cost will be Rs. 20,000. Cost of building gas well is Rs. 40,000 only due to shallow depth of gas field. Working capital requirements in second and third year are Rs.30,000 and Rs.40,000 respectively. The total project life will be five years. Years 1 2 3 4 5 Discounted cash flows (Rs.) 15,000 25,000 29,200 30,000 40,000 Project C: Extraction in East region Project C includes extraction in east region of Pakistan that has deep petroleum field according to hydrocarbon exploration survey and requires drilling rig of Rs.540,000. Installation cost will be Rs.80,000. Due to technological obsolescence the drilling rig will not be useable after fifth year and the salvage value is estimated around Rs.70,000. The total project life is four years. Years 1 2 3 4 Discounted cash flows (Rs.) 144,000 153,000 150,000 235,000 Project D: Extraction in West region Project D includes extraction in west region of Pakistan with estimated cost of drilling rig is Rs.750,000. For only this project, company requires to hire an extraction consultant to oversee the technical aspects during the life of the project at a cost of Rs.200,000. However, if the project does not turn out to be financially feasible then his contract will be cancelled by paying him Rs.100,000. Installation cost required is 20% of the cost of drilling rig. Working capital requirement is Rs.200,000 in second year. Project has total life of six years. Years 1 2 3 4 5 6 Discounted cash flows (Rs.) 140,000 180,000 110,000 220,000 230,000 200,000
Required: 1) Calculate Net Present Value (NPV) and Profitability Index (PI) of each project.
2) Rank the projects on the basis of Profitability Index (PI). Allocate the budget based upon this ranking and calculate NPV of selected portfolio of projects.
3) Rank the projects on the basis of NPV. Allocate the budget based upon this ranking and calculate NPV of selected portfolio of projects.
4) Which portfolio of projects should be selected by the company and why?
For Better understanding please view the uploaded, attached file.
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