Optimal Oil & Gas is a Calgary based drilling company that contracts its fleet of mobile drilling rigs and personnel to oil and gas exploration companies. The current annual cost structure of running a drilling rig in this market is:

Operating Costs $15,000.000

Labour Costs 4,000,000

Maintenance Costs 1,000,000

Amortization Costs 2,000,000

Other fixed Costs 4,000,000

Head Office received a project proposal today from the drilling supervisor to replace one mobile drilling rig that it had acquired eight years ago for $22,500.000 and carries a book value of $6,000,000. Another drilling company has offered Optimal $7,200,000 for its current rig if Optimal decides to replace it. If new components are not acquired, the current rig could still be used for 10 years, but with a salvage of $0 at the end.

A new rig could be fabricated and shipped from Nisku, Alberta, and then set up on a drilling location for a total cost of $32,000.000. The new rig would have a salvage of $6,400,000 at the end of 10 years. An initial investment of $500,000 in Net Working Capital is required.

The new rig is purported to save $5,200,000 in annual operating costs for each of the first 6 years and then save $3,800,000 in annual operating costs for each of the following 4 years. Annual labour cost would be 10% lower than experienced this year.

Optimal Oil & Gas has a corporate tax rate of 40%, it could finance the purchase of a new rig with a bank loan at 8%, and its project hurdle rate will be 12%. Drilling rigs and all their components have a CCA rate of 30%.

REQUIRED:

1. Should Optimal Oil & Gas replace the rig? Use the net present value method to calculate the return on the proposal, and then state your decision. Show all your work