A simple example of project valuation with end-point restoration obligations

The project has three dates and two periods.

The initial investment is and it is the basis for depreciation tax effects.
)(
) is realized, plus effects from depreciation
At date 1, cash flow (
. Here is the
effective factor that the particular depreciation method produces and is the income tax rate. The cash
) where is the unit
flow is equal to the quantity sold times the tax adjusted unit contribution (
price and is the variable unit variable cost. Fixed costs are taken to be zero.
At date 2 the only cash flow is the expense of restoration. This expense will be taken to be a convex
function of the amount sold. To use a simple model, it will be a quadratic function in .
Denoting as the risk-adjusted discount factor and as the risk-free discount factor, the net present
value of the project is:
(

)(

This project is financed in full with equity money, and the usual assumption of price-taking applies. The
maximization of the npv yields an optimal quantity to be sold:
(

)(

Substitution of this expression into the npv formula simplifies to:

Where:
(

Taken together, equations [1] and [2] tell that in this very simplified situation the actual optimal value
for the net present value depends on the risk-adjusted discount factor only through the effective
investment given by equation [3]. For a multi-period case, this is not true.
One interesting aspect of the problem is the relationship between the investment and the production
capacity it buys , compared to the optimal extraction . Are there incentives to overinvest, in the
sense that initially it is the case that
?