Final answer:
Howell Petroleum, Incorporated is evaluating a generation project with cash flows of -$39,500,000 in year 0, $63,500,000 in year 1, and -$12,500,000 in year 2. To evaluate the project, we use the concept of Net Present Value (NPV) by calculating the present value of all cash flows and comparing it to the initial investment. We can determine the project's profitability by finding the discount rate that makes the NPV equal to zero, known as the internal rate of return (IRR).
Step-by-step explanation:
Howell Petroleum, Incorporated, is evaluating a generation project with the following cash flows:
- Year 0: -$39,500,000
- Year 1: $63,500,000
- Year 2: -$12,500,000
To evaluate this project, we can use the concept of Net Present Value (NPV). NPV calculates the present value of all cash flows generated by the project and compares it to the initial investment. If the NPV is positive, it indicates that the project is profitable. Let's calculate the NPV for this project:
- Year 0: -$39,500,000 / (1 + r)^0 = -$39,500,000
- Year 1: $63,500,000 / (1 + r)^1 = $63,500,000 / (1 + r)
- Year 2: -$12,500,000 / (1 + r)^2 = -$12,500,000 / (1 + r)^2
To calculate the NPV, we sum up the present values of all the cash flows:
NPV = -$39,500,000 + $63,500,000 / (1 + r) - $12,500,000 / (1 + r)^2
We can now solve for the discount rate 'r' that makes the NPV equal to zero. This rate, known as the internal rate of return (IRR), represents the project's profitability. By solving the NPV equation, we can determine if the project is viable.