BP recently evaluated a proposal for switching to a new system of storage for refined petroleum products (which loses less product to evaporation). According to their analysis of the project, the initial investment required for the project is $50 million, and the project is expected to yield $10 million in returns (the value of the additional product available for sale, evaluated at the expected price of petroleum products) over a 9 year period).
a. What is the NPV of this project, evaluated at a 10% discount factor and at a 15% discount factor?
b. Historically, BP has used interest rates (discount factors) of 10% and 15% to evaluate investment projects; these rates incorporate BP's cost of capital and a risk-assessment factor. Generally, BP has used a 10% rate to evaluate safer and a 15% rate to evaluate riskier projects. Does this project appear (to you) to fall into the "safer" or "riskier" category? Why? How does that influence your choice of which rate is the "correct" rate to use?
c. Prices of petroleum products have been highly volatile. (Since 1994, the US average price (weekly) of premium gasoline has averaged $1.89 per gallon, with a standard deviation of $0.73; for regular, the average weekly price since 1990 has been $1.56, with a standard deviation of $0.68; for diesel, an average of $1.76 with a standard deviation of $0.83). Suppose you expect the volatility of petroleum product prices to increase significantly over the next nine years (i.e., an unchanged mean, but with standard deviations that are $1.08 for premium, $1.01 for regular, and $1.25 for diesel). What effect is this likely to have on your evaluation of this project? Why?
Below are my answers.
10 million*(1-(1/(1+.1)^9))/.1 - 50 million = 7,590,238
10 million*(1-(1/(1+.15)^9))/.15 - 50 million = -2,284,160
I think that the project generally fall into the "safer" category as the project's scope is a transfer from one method to another ...
The solution determines the increase in volatility.