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Question(s) / Instruction(s):

A task force of capital budgeting analysts at Seger Ltd. collected the following data concerning the drilling and production of known petroleum reserves at an offshore location:        

Investment in rigging equipment and related personnel costs required to pump the oil $4,870,000          

Net increase in inventory and receivables associated with the drilling and production of the reserves. Assume this investment will be recovered at the end of the project.                                               $905,000             

Net cash inflow from operations for the expected life of the reserves, by year:                                 

2010                                      $1,500,000          

2011                                      $2,975,000          

2012                                      $1,330,000          

Salvage value of machinery and equipment at the

end of the well's productive life                                                                                                                               $850,000             

Cost of capital                                                                                                                                                   12%

Required:

(a)          Calculate the net present value of the proposed investment in the drilling and production operation. Assume that the investment will be made at the beginning of 2010, and the net cash inflows from operations will be received in a lump sum at the end of each year. (Ignore income taxes.)

(b)          What will the internal rate of return on this investment be relative to the cost of capital?

(c)           Differences between estimates made by the task force and actual results would have an effect on the actual rate of return on the project. For each estimate, state the effect on the actual ROI if the estimate turns out to be less than the actual amount finally achieved.

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