Consolidated Oilfields plc is interested in exploring for oil near the west coast of Australia. The Australian government is prepared to grant an exploration licence to the company for a five-year period for a fee of £300,000 p.a.

The option to acquire the rights must be taken immediately, otherwise another oil company will be granted the rights. However, Consolidated Oilfields 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 £10,400,000, 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 Oilfields. 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 amounts of high-quality crude oil. The survey cost £250,000 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 for Years 2–5 when the oilfield is operational.

Year 2 3 4 5 Sales Less expenses Wages and salaries Materials and consumables Licence fee Overheads Depreciation Survey cost written off Interest charges Profit

£000 550 340 600 220 2,100 250 650

£000 7,400 4,710 2,690

£000 580 360 300 220 2,100

–

650

£000 8,300 4,210 4,090

£000 620 410 300 220 2,100

–

650

£000 9,800 4,300 5,500

£000 520 370 300 220 2,100

–

650

£000 5,800 4,160 1,640 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 the Australian government at the end of each year.

2.

The overheads contain an annual charge of £120,000, 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 remainder 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 £10,400,000 will be sold at the end of the licence period for £2,000,000.

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 £150,000 for the period the cutting tool is on loan.

6.

The project will require an investment of £650,000 working capital from the end of the first year to the end of the licence period.

The company has a cost of capital of 10 per cent.

Ignore taxation.

Required

(a) Prepare calculations that will help the company to evaluate further the profitability of the proposed project.

(b) State, with reasons, whether you would recommend that the project be undertaken.

(c) Explain how inflation can pose problems when appraising capital expenditure proposals, and how these problems may be dealt with.
(Certified Diploma)