How to Calculate the Present Value of an Oil Pipeline's Cash Flows
What is the present value of the oil pipeline's cash flows if its cash flows are assumed to last forever?
To calculate the present value of the oil pipeline’s cash flows if its cash flows are assumed to last forever, given that the volume of oil shipped is declining and cash flows are expected to decline by 2.0% per year.
Answer:
The present value of the pipeline’s cash flows if its cash flows are not expected to last forever can be found using the formula:
PV of the pipeline's cash flows that do not last forever = (CF1 ÷ (1 + r)^1) + (CF2 ÷ (1 + r)^2) + … + (CFn ÷ (1 + r)^n)
where CF = Cash flow, r = Discount rate
CF1 = $2.1 million since this is the amount of cash return generated over the coming year.
CFn = 0 since the cash flows are expected to decline by 2.0% per year, and thus, the pipeline’s cash flows are not expected to last forever.
Therefore, CF1 = $2.1 million, r = 5%
PV of the pipeline's cash flows that do not last forever = ($2.1 million ÷ (1 + 5%)^1) = $2 million
Details of the Calculation:
When calculating the present value of the oil pipeline's cash flows, it is important to consider the expected decline in cash flows over time. In this scenario, where the cash flows are not expected to last forever, the formula takes into account the discount rate and the expected cash flows.
By using the provided formula and plugging in the values for CF1, CFn, and the discount rate, we can determine that the present value of the pipeline's cash flows that do not last forever is $2 million.
It is crucial to understand the implications of declining cash flows and how they can impact the overall present value of an investment like an oil pipeline. By considering these factors, investors can make informed decisions regarding the profitability and sustainability of such assets.