Page 5 of 5 Case 2: Investment criteria-methods (10 marks) Gulfnite LLC is a leading producer of light commercial vehicle. Its projetcs typically has a short life as it introduces new models periodically. You have recently joined Gulfnite LLC as a financial analyst reporting to Mr.Danny, the CFO of the company. He has provided you the following information about three projetcs, A and B that are being considered by the Executive Committee of Gulfnite LLC Project A is an extension of an existing line. Its cash flow will decrease over time. Project B involves a new product. Building its market will take some time and hence its cash flow will increase oer time. The expected net cash flows of the two projects are as follows. . Year 0 1 2 3 4 Project A (Ro.) (1000) (1300) (800) (250) 3000 4000 Project B (Ro.) (1600) 200 300 400 800 1000 5 Mr.Danny believes that both projetcs have risk characteristics similar to the average risk of the firm and hence the firms cost of capital of 12% will apply to them. You are required to: 1. Construct the NPV profiles for projects A and B. (2.5 marks) 2. What is the IRR of each project? (2.5 marks) 3. What is the pay back period for each projects ? (2.5 marks) 4. If the two projetcs are mutually exclusive and the cost fo capital is 10 percent, which project should the firm invest in ? (2.5 marks) Case 1 - Relevant Cash Flows and Risk Adjusting Technique (10 marks) Shell Oman engages in off-shore drilling operations for oil deposits. The Strait of Hormuz is a strait between the Persian Gulf and the Gulf of Oman. The company has recently spent $10 million in surveying a region in the Strait of Hormuz and has found the existence of significant oil deposits there. The sea bed in the region, however, has a rock formation that may make access to the oil deposits difficult. The total oil deposits in the region have been estimated at 50 million barrels but the amount extracted will vary according to the conditions faced when drilling operations commence. The company's senior geologist believes that three possible outcomes are likely from drilling operations and has made the following estimates concerning the percentage of total oil deposits that will be extracted under each outcome: Outcome Probability Percentage of total oil deposits extracted 100% 1 2 3 40% 25% 0.1 0.5 0.4 If the company decides to go ahead with the drilling operation, an immediate payment of $20 million for drilling rights, along with annual payments of $5 for each barrel of oil extracted must be made to the government. Equipment costing $125 million must be acquired immediately but drilling will not commence until the second year of the four-year licence period. It is expected that, whichever of the above outcomes arise, the oil will be extracted evenly over the drilling period. Annual operating costs (excluding any payments to the government) will be $120 million in the first year and $160 million for each of the remaining three years of the licence. At the end of the licence period, the equipment will be sold at a price that is equal to its original cost less $8 for each barrel of oil that has been extracted. Oil prices over the period of the drilling licence are estimated to be as follows: Year Price per barrel 1 $70 2 $85 3 $75 4 $100 The company has a cost of capital of 14%. No tax rate is applicable. Required: (a) Identify the relevant cash flows in above case and calculate Cash flow after tax for four years. (5 marks) (b) Calculate the expected net present value (ENPV) of the investment proposal