Case Study of the Western Company
I do not agree with the decision made by the analyst regarding the natural gas project. Assuming the 4 percent inflation premium holds true, the increase in revenues will outpace the increase in operating costs, resulting in greater profitability. In the analysts figures they used an inflation adjusted rate without adjusting the cash flows for inflation causing an undervaluation of the project. 2. Classes 10 b. By using the NP calculation, Western Is only using the known Information In an all or nothing scenario.
While useful In passive Investing, such as the bond arrest, this type of calculation leaves out many factors in the budgeting for projects. By using NP, the firm is ruling out the active management of projects, and the decisions that can accompany that management. In the management of projects there are always options available: the firm has the ability to sell the project, abandon it, invest further, or wait and see. The value of an option is that it allows the firm to deal with the uncertainty in a flexible manner and then generate the expected value of a project. . Classes 11 c. Western should proceed immediately with the pipeline project. In either scenario the project has a positive NP. While the NP to delay is significantly greater than the NP to proceed, the benefits of Increased Inflation will still be felt If the project proceeds. Therefore, Western should take the lower present Minimal cost of investment. 4. Classes 12 d. Under the conditions set forth, without the possibility of varying conditions or abandonment, it is not recommended the firm move ahead on the project.
The expected NP at a 10% cost of capital is ($12,230) with a C.V. that suggests a higher cost of capital would be appropriate. E. If abandonment is an option, it would be recommended that the project be accepted at any of the cost of capital figures. With the assumption that cash flows will vary, depending on the condition of the paper market, It would be recommended that the project not be accepted under any given cost of capital. With over a 55% chance of abandonment by the third year, before any Investment Is recaptured, and a negative NP, this Is not a prudent project to undertake.