Question

Comparison of Payback, NPV, and IRR Question 4: Exxon is considering drilling for oil in the gulf coast near Texas. The proposed drilling site has the following information: (a) A rig will need to be setup which costs $1,200,000,000 in Year 0. (b) It will actually cost $100,000,000 for Exxon to shut down the rig and comply with EPA regulations at the end of its useful life in Year 20). (c) The rig will produce operating cash flows of $150,000,000 a year for 20 years (d) Exxon's discount rate on new drilling projects in the gulf coast is currently 19% a) What is the payback period, in years for this project? b) What is the project's NPV? c) Is the project's IRR over, under, or exactly 19%? d) Should the project be accepted under the payback rule? Under the NPV rule? Under the IRR rule?

Answer 1

Initial Cost = $ 1,200,000,000

Annual Cash Flow = $ 150,000,000

Ans a) Payback Period = Initial Investment / Annual Cash Flow

= $ 1,200,000,000 / $ 150,000,000 = 8 Years

Ans b)

Discount Rate = 19%

Duration = 20 Years

Initial Cost = $ 1,200,000,000

Annual Cash Flow = $ 150,000,000

Shutdown Cost = $ 100,000,000

NPV = Cash Inflows / ( 1+r)^n - Initial Investment

NPV = $ - 437,954,299.05 (Rounded to 2 decimal)

	Y0	Y1	Y2	Y3	Y4	Y5	Y6	Y7	Y8	Y9	Y10	Y11	Y12	Y13	Y14	Y15	Y16	Y17	Y18	Y19	Y20
Initial Cost	-1,20,00,00,000
Annual Cash Flow		15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000	15,00,00,000
Shutdown Cost																					-10,00,00,000
Discount Rate	19%
PV	-1,20,00,00,000	12,60,50,420.17	10,59,24,722.83	8,90,12,372.13	7,48,00,312.71	6,28,57,405.64	5,28,21,349.28	4,43,87,688.47	3,73,00,578.54	3,13,45,023.99	2,63,40,356.29	2,21,34,753.19	1,86,00,632.93	1,56,30,783.97	1,31,35,112.58	1,10,37,909.73	92,75,554.40	77,94,583.53	65,50,070.19	55,04,260.67	15,41,809.71
NPV	-43,79,54,299

And c)

IRR is a point where NPV is equals to Zero.

NPV = Cash Inflows / ( 1+r)^n - Initial Investment

0 = Cash Inflows / ( 1+r)^n - Initial Investment = IRR

Here we need to identify r (discounting factor where present value will be zero)

IRR = 10.767

And d)

Project can be accepted under Payback period as we are able to recover investments under the project period.

Project should be rejected under NPV method as we are getting negative NPV

Project should be rejected under IRR method as IRR is less than the discount rate of 19%

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