(Payback period and NPV calculations)Plato Energy is an oil and gas exploration and development company located in Farmington, New Mexico. The company drills shallow wells in hopes of finding significant oil and gas deposits. The firm is considering two different drilling opportunities that have very different production potentials. The first is in the Barnett Shale region of central Texas and the other is in the Gulf Coast. The Barnett Shale project requires a much larger initial investment but provides cash flows (if successful) over a much longer period of time than the Gulf Coast opportunity. In addition, the longer life of the Barnett Shale project also results in additional expenditures in year 3 of the project to enhance production throughout the project's 10-year expected life. This expenditure involves pumping either water or

CO2

down into the wells in order to increase the flow of oil and gas from the structure. The expected cash flows for the two projects are as follows:

LOADING...

.

a.What is the payback period for each of the two projects?

b.Based on the payback periods, which of the two projects appears to be the best alternative? What are the limitations of the payback period ranking? That is, what does the payback period not consider that is important in determining the value creation potential of these two projects?

c.If Plato's management uses a discount rate of

21.9

percent to evaluate the present values of its energy investment projects, what is the NPV of the two proposed investments?

d.What is your estimate of the value that will be created for Plato by the acceptance of each of these two investments?

Question content area bottom

Part 1

a.Given the cash flow information in the table, the payback period of the Barnett Shale project is

4.004.00

years.(Round to two decimal places.)

Part 2

The payback period of the Gulf Coast project is

1.61.6

years.(Round to two decimal places.)

Part 3

b.Based on the payback periods calculated above, the project which looks best using the payback criterion is

the Gulf Coast project

. (Select from the drop-down menu.)

Part 4

Which of the following are limitations of the payback period ranking, that is, what does the payback period not consider that is important in determining the value creation potential of these two projects?(Select the best choice below.)

A.

There is no clear-cut way to define the cutoff criterion for the payback period that is tied to the value creation potential of the investment.

B.

The payback method ignores the time value of money.

C.

The payback method ignores cash flows that are generated by the project beyond the end of the payback period.

D.

All of the above.

Your answer is correct.

Part 5

c.If Plato's management uses a discount rate of

21.9%

to evaluate the present values of its energy investment projects, then the NPV of the Barnett Shale project is

$enter your response here.

(Round to the nearest dollar.)

Year		Barnett Shale		Gulf Coast
0		$(5,200,000)		$(1,200,000)
1		2,080,000		750,000
2		2,080,000		750,000
3		(1,040,000)		450,000
4		2,080,000		150,000
5		1,880,000
6		1,880,000
7		1,880,000
8		800,000
9		450,000
10		150,000