28. Project analysis (S10.1–S10.2) New Energy is evaluating a new biofuel facility. The plant would cost $4,000 million to build and has the potential to produce up to 40 million barrels of synthetic oil a year. The product is a close substitute for conventional oil and would sell for the same price. The market price of oil currently is fluctuating around $100 per barrel, but there is considerable uncertainty about future prices. Variable costs for the organic inputs to the production process are estimated at $82 per barrel and are expected to be stable. In addition, annual upkeep and maintenance expenses on the facility will be $100 million regardless of the production level. The plant has an expected life of 15 years, and it will be depreciated straight-line over 10 years. Salvage value net of clean-up costs is expected to be negligible.

Demand for the product is difficult to forecast. Depending on consumer acceptance, sales might range from 25 million to 35 million barrels annually. The discount rate is 12% and New Energy’s tax bracket is 25%.

a. Find the project NPV for the following combinations of oil price and sales volume. Which source of uncertainty seems most important to the success of the project?

Oil Price Annual Sales (millions of barrels) $80/Barrel $100/Barrel $120/Barrel 25 30 35

b. At an oil price of $100, what level of annual sales, maintained over the life of the plant, is necessary for NPV break-even? (This will require trial and error unless you are familiar with more advanced features of Excel such as the Goal Seek command.)

c. At an oil price of $100, what is the accounting break-even level of sales in each year? Why does it change each year? Does this notion of break-even seem reasonable to you?

d. If each of the sales figures in the table in part

(a) is equally likely, what is the NPV of the facility?

e. Why might the facility be worth building despite your answer to part (d)? (Hint: What real option may the firm have to avoid losses in low-oil-price scenarios?)