ConocoPhillipss (COP) Natural Gas and Gas Products Department (NG&GP) manages all of the companys activities relating to the gathering, purchasing, processing, and sale of natural gas and gas liquids. Chris Simpkins, a recent graduate, was recently hired as a financial analyst to support the NG&GP department. One of Chriss first assignments was to review the projections for a proposed gas purchase project that were made by one of the firms field engineers. The cash flow projections for the ten-year project are found in Exhibit P3-12.1 and are based on the following assumptions and projections:

The investment required for the project consists of two components: First, there is the cost to lay the natural gas pipeline of $1,200,000. The project is expected to have a ten-year life and is depreciated over seven years using a seven-year modified accelerated cost recovery system (MACRS).20 Second, the project will require a $145,000 increase in net working capital that is assumed to be recovered at the termination of the project.

²⁰ Modified accelerated cost recovery system (MACRS) uses a shorter depreciable life for assets, thus giving businesses larger tax deductions and cash flows in the earlier years of the project life relative to those of straight-line depreciation.

The well is expected to produce 900,000 cubic feet (900 MCF) per day of natural gas during year 1 and then decline over the remaining nine-year period (365 operating days per year). The natural gas production is expected to decline at a rate of 20% per year after year 1.

In addition to the initial expenditures for the pipeline and additional working capital, two more sets of expenses will be incurred. First, a fee consisting of 50% of the wellhead natural gas market price must be paid to the producer. In other words, if the wellhead market price is $6.00 per MCF, 50% (or $3.00 per MCF) is paid to the producer. Second, gas processing and compression costs of $0.65 per MCF will be incurred.

There is no salvage value for the equipment at the end of the natural gas lease.

The natural gas price at the wellhead is currently $6.00 per MCF.

The cost of capital for this project is 15%.

Year	0	1	2	3
Investment	$ 1,200,000
Increase in NWC	145,000
MACRS depreciation rate (7 years)		0.1429	0.2449	0.1749
Natural gas wellhead price (per MCF)		$ 6.00	$ 6.00	$ 6.00
Volume (MCF/day)		900	720	576
Days per year		365
Fee to producer of natural gas (per MCF)		$ 3.00	$ 3.00	$ 3.00
Compression and processing costs (per MCF)		0.65	0.65	0.65
Cash Flow Calculations
Natural gas wellhead price revenue		$ 1,971,000	$ 1,576,800	$1,261,400
Lease fee expense		985,500	788,400	630,720
Compression and processing costs		213,525	170,820	136,656
Depreciation expenses		171,480	293,880	209,880
Net operating profit		600,495	323,700	284,184
Less taxes (40%)		(240,198)	(129,480)	(113,674)
Net operating profit after tax (NOPAT)		360,297	194,220	170,510
Plus depreciation		171,480	293,880	209,880
Return of net working capital
Project free cash flow	$(1,345,000)	$ 531,777	$ 488,100	$ 380,390

Alternate View

4	5	6	7	8	9	10
0.1249	0.0893	0.0893	0.0893	0.0445
$ 6.00	$ 6.00	$ 6.00	$ 6.00	$ 6.00	$ 6.00	$ 6.00
461	369	295	236	189	151	121
$ 3.00	$ 3.00	$ 3.00	$ 3.00	$ 3.00	$ 3.00	$ 3.00
0.65	0.65	0.65	0.65	0.65	0.65	0.65
$1,009,152	$807,322	$645,857	$516,686	$413,349	$330,679	$264,543
504,576	403,661	322,929	258,343	206,674	165,339	132,272
109,325	87,460	69,968	55,974	44,779	35,824	28,659
149,880	107,160	107,160	107,160	53,400
245,371	209,041	145,801	95,209	108,495	129,516	103,613
(98,148)	(83,616)	(58,320)	(38,083)	(43,398)	(51,806)	(41,445)
147,223	125,425	87,480	57,125	65,097	77,710	62,168
149,880	107,160	107,160	107,160	53,400
						145,000
$ 297,103	$232,585	$194,640	$164,285	$118,497	$ 77,710	$207,168

NPV = $280,051

IRR= 22.43%

Question:

Should Chris recommend that the project be undertaken?

Explain your answer. What reservations, if any, should Chris have about recommending the project to his boss?