12-14 Timing DifferencesThe Ewert Exploration Company is considering two mutually exclusiveplans for extracting oil on property for which it has mineral rights. Bothplans call for the expenditure of $10 million to drill development wells.Under Plan A, all the oil will be extracted in 1 year, producing a cash flowat t 5 1 of $12 million; under Plan B, cash flows will be $1.75 million peryear for 20 years.

a. What are the annual incremental cash flows that will be available toEwert Exploration if it undertakes Plan B rather than Plan A? (Hint:Subtract Plan A's flows from B's.)

b. If the company accepts Plan A and then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) wouldcause the cash flows from reinvestment to equal the cash flows fromPlan B?

c. Suppose a firm's cost of capital is 10%. Is it logical to assume that the firmwould take on all available independent projects (of average risk) withreturns greater than 10%? Further, if all available projects with returnsgreater than 10% have been taken, would this mean that cash flows frompast investments would have an opportunity cost of only 10% becauseall the firm could do with these cash flows would be to replace moneythat has a cost of 10%? Finally, does this imply that the cost of capital isthe correct rate to assume for the reinvestment of a project's cash flows?

d. Construct NPV profiles for Plans A and B, identify each project's IRR,and indicate the crossover rate.