Plato Energy is an oil and gas exploration and development company located in Farmington, New Mexico. The company drills shallow wells in hopes of finding significant oil and gas deposits. The firm is considering two different drilling opportunities that have very different production potentials. The first is in the Barnett Shale region of central Texas and the other is in the Gulf Coast. The Barnett Shale project requires a much larger initial investment but provides cash flows (if successful) over a much longer period of time than the Gulf Coast opportunity. In addition, the longer life of the Barnett Shale project also results in additional expenditures in Year 3 of the project to enhance production throughout the project’s 10-year expected life. This expenditure involves pumping either water or CO2 down into the wells in order to increase the flow of oil and gas from the structure. The expected cash flows for the two projects are as follows:
a. What is the payback period for each of the two projects?
b. Based on the calculated payback periods, which of the two projects appears to be the best alternative? What are the limitations of the payback period ranking? That is, what does the payback period not consider that is important in determining the value creation potential of these two projects?
c. If Plato’s management uses a 20 percent discount rate to evaluate the present values of its energy investment projects, what is the NPV of the two proposed investments?
d. What is your estimate of the value that will be created for Plato by the acceptance of each of these two investments?
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