Project risk, required rate ofreturn. Esso Petroleum is considering two investment projects.

The first project, viewed as a high-risk investment, is drilling equipment for oil exploration activities. Esso expects the drilling equipment to cost $1.2 million and result in operating cash flows before taxes of $444,000 per year for five years. The equipment has a five-year life and a terminal disposal price of zero.

The second project, viewed as a low-risk investment, is production equipment that will improve the yield in Esso’s refinery. Esso expects the production equipment to cost $960,000 and result in operating cash flows before taxes of $360,000 per year for four years. The equip¬

ment has a four-year life and a terminal disposal price of zero. Esso’s income tax rate is 30%.

The production and drilling equipment capital cost allowance rate is 25%, declining balance.

Required 1. Which project has the higher net present value if Esso uses an after-tax required rate of return (RRR) of 12% for both projects?

2. A manager at Esso objects to the calculations in requirement 1 arguing that riskier invest¬

ments should have a higher RRR. Suppose Esso requires an 18% after-tax RRR for highrisk investments and a 12% after-tax RRR for low-risk investments. Which project has the higher net present value?

3. Wfltich project do you favour? Why?