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Invest and Earn Problem

Invest and Earn Problem

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Invest and Earn Problem

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  1. Invest and Earn Problem • Negative investment cash flow followed by positive return cash flow • Evaluate with IRR or NPV • Traps • Infinite cash flow • Truncate it • Goes negative later • don’t use IRR • evaluate how you will handle negative flow in real life and then do it to the cash flow • Tweek the IRR by diverting future earnings at the external rate to cover the red ink

  2. One More Trick • The sunk cost problem • Prior to making an investment most companies spend money to develop or ready the opportunity • Example - Oil Industry • Two biggest costs are “finding cost” and “lifting cost”

  3. Example • Bushy Boys Oil spends $200,000,000 dollars a year for 3 years to find the Dead Seal oil field. The exploration data shows that the oil field contains 100,000,000 barrels of recoverable oil. It will cost $50,000,000 over the next year to bribe lobby officials, run a warm fuzzy PR campaign and get the permits to develop the field. It will then cost $400,000,000 to develop the wells to pump the oil field and to develop the pipeline infrastructure to move the oil.

  4. Example Continued • It will cost $11/barrel to lift the oil to the surface and another $1.50/barrel to move it to market. If oil will sell for $25/barrel and the oil field will be pumped down evenly over the next 10 years, can the investment yield a 20% rate of return?

  5. Cash Flow Where is the point of decision? What Kind of Problem is this? Invest and Earn Problem 125,000,000/year -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 -50,000,000 -400,000,000 -200,000,000

  6. Sweeping Into the Pot -$50,000,000 * 0.833 = -$41,665,000 What Did I Forget to Do? -$400,000,000 * 0.6944 = -$277,760,000 $125,000,000 * 4.192 =$524,000,000 * 0.6944 = $363,865,600 Sum Up = $44,440,600 125,000,000/year -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 -50,000,000 -400,000,000 -200,000,000

  7. Wrapping Up What About My $600,000,000 Investment to Find That Oil Field $44,440,600 NPV -3 -2 -1 0 1 2

  8. Sunk Costs Can your decision change whether that cost occurs?