20. Fudge factors (S9.3) An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes 272 Part Two Risk oil, there is still uncertainty about the amount of oil produced: 40% of new wells that strike oil produce only 1,000 barrels a day; 60% produce 5,000 barrels per day.

a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of

$100 per barrel.

b. A geologist proposes to discount the cash flows of the new wells at 30% to offset the risk of dry holes. The oil company’s normal cost of capital is 10%. Does this proposal make sense? Briefly explain why or why not.