The Present Value of an Oil Pipeline's Cash Flows

Calculating the Present Value of Cash Flows for an Oil Pipeline

You own an oil pipeline which will generate $2 million cash return over the coming year. The pipeline’s operating costs are negligible, and it is expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 4% per year. The discount rate is 10%. What is the PV of the pipeline’s cash flows if its cash flows are assumed to last forever?

Question:

What is the present value of the oil pipeline's cash flows with perpetuity assumptions?

Answer:

$14,285,714.29

Explanation:

We can use the discounted cash flow model formula for a perpetuity:

PV of infinite cash flows = cash flow in 1 year / (required rate of return - growth rate)

• cash flow in 1 year = $2,000,000
• required rate of return = 10%
• growth rate = -4%

PV of infinite cash flows = $2,000,000 / (10% + 4%) = $14,285,714.29

This formula is used to determine the present value of a firm's future cash flows.