After calculating the risk adjusted discount rate for all four projects individually and coupled with Alaska a Oil’s Drilling Project, it is found that only Projects B, C, and D meet the required rate of return for the a associated amount of risk. Project D, however, provides the most return on investment with the least am mount of risk once it is coupled with the oil drilling project. 2 Introduction David Fay, financial vice president of Alaska Oil Corporation, has a very import ant decision to make. Alaska Oil has been granted offshore oil concessions from Russia, on the e condition that it takes on t least one of four investment projects.
The four projects have all been paper Veda by the World Bank as being economically feasible, however they all have considerably high risk. Dave id has been charged with the task of determining who ICC project, if any, Alaska Oil should undertake. Analysis The information given in Table 2 is the cost of equity estimates for domestic I industries. This information can be used to evaluate the AIR and MIR calculated for each oft he four projects. Appendix A shows the AIR and MIR using both 16 percent and 26 percent as the paper primate cost of capital for he offshore oil project and all four investment projects.
The $25 million spent on geological surveys is not included in the calculations for the oil project. This cost is considered a us ink cost (R) and is not an incremental future cash flow associated with the decision to produce the pro duct, so it is not included in the capital budgeting analysis. For these projects, the MIR is more meanings LU in the decision making process because it assumes the positive cash flows are reinvested at the firms cost of capital instead of the regular AIR. This means the MIR reflects the actual cost and profitability f a project more accurately than the regular AIR.
Since the projects are not mutually exclusive Project D should be based on its own 4-year life rather than the longer lives of the other projects. Up to t his point, Project B seems to be the best project for Alaska Oil to undertake. Capital budgeting refers to the process we use to make decisions concerning I investments in the long-term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firms are used to invest in assets that will enable the firm to generate revenues seven real years into the future.
When evaluating a capital budgeting project, we need to examine the risk ass associated with the project and how the existing assets of the firm will be affected if the project is accept deed. The reason we need to 3 evaluate the risk of a project is to determine if the appropriate required rate o f return is used to compute the project’s NP (or to compare to its AIR). If a firm is considering a project that is much riskier than the existing assets, then it makes sense that the firm should expel CT to earn a higher return on the project than on its existing assets. The factors that affect the relative RI kinkiness are explained below:
A. Timing Pattern – The longer the payback the more risky a project is considered d to be. So Project A would be the most risky while Project D would be the least risky. B. The Correlation of Cash Flow – Project D is the least risky because it is negative correlated with Alaska Oil’s cash flows. Project A would be the most risky became use it is positively correlated. C. Projects B and C are considered the least risky because they are not correlate d while Project D is considered to be the most risky because it is highly correlated. D. Country Risk – All four projects will be considered more risky because they AR all in Russia.
The rockiness is increased because of factors like exchange risk and pop Leticia risk Appendix B shows the expected rate of return for Alaska Oil if it accepts any o f the four projects in conjunction with the Oil Drilling project. Based on these calculations, project t C seems to be the best project for Alaska Oil to undertake. Appendix C shows the risk-adjusted discount rates for Alaska Oil, the oil drilling g projects, and the four investment projects. It also shows the weighted average beta coefficients for each of the projects in conjunction with the oil drilling project.
The chart shows the required rate of r turn for all the projects along with the expected return for all the projects individually, and all four pr Ejects in conjunction with the oil drilling project. The chart also shows the McMahon Loan plotted alone g the SIMI_ and the expected return. These calculations show that Projects B, C, and D are all ace potable in conjunction with 4 the oil drilling project. Also, the McMahon Loan is acceptable. They are all a above the risk adjusted required rate of return. Based on the risk-adjusted discount rates found earlier, the Naps of the four projects are as follows:
Project A Project B. Project C: Project D. Doug Caldwell, President of Alaska Oil, has made the argument that either Pr Eject B or project C should be accepted along with the oil drilling project, because if the oil drilling project is successful the Russian economy will boom. Both Project B and Project C would therefore be unfit and would have higher returns. The argument Doug makes is accurate because right now boot h Projects 8 and C have negative Naps. But, if an economic boom can result in at least a 10% increase on returns, then both projects would have a positive NP using the risk-adjusted rates.
There are other considerations that Alaska Oil should take into account before e making a decision. They should make sure that the political environment in Russia is favorable to the oil drilling project and any of the investment projects. If there is a chance that any rules or regulation ins could change in the near future, that might affect the profitability of the projects.