The Southwestern Oil Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $12 million to drill development wells. Under Plan A, all the oil will be extracted in one year, producing a cash flow at the end of Year 1 (t = 1) of $14.4 million. Under Plan B, cash flows will be $2.1 million per year for 20 years.

a. Construct NPV profiles for Plans A and B, identify each project’s IRR, and indicate the approximate crossover rate of return. (To compute the exact crossover rate, see footnote 16 in this chapter.)

b. Suppose a company has a required rate of return of 12 percent, and it can get unlimited funds at that cost. Is it logical to assume that it would take on all available independent projects (of average risk) with returns greater than 12 percent? Further, if all available projects with returns greater than 12 percent are purchased, would this mean that cash flows from past investments would have an opportunity cost of only 12 percent because all the firm could do with these cash flows would be to replace money that has a cost of 12 percent? Finally, does this imply that the required rate of return is the correct rate to assume for the reinvestment of a project’s cash flows?

c. Compute the MIRR for each project. Which project should Southwestern purchase? Why?