24. Fudge factors (S9.3) An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2 million for 15 years. These are real (inflation-adjusted) cash flows.

The beta for producing wells is 0.9. The market risk premium is 8%, the nominal risk-free interest rate is 6%, and expected inflation is 4%.

The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 20% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10 million investment.

Ignore taxes and make further assumptions as necessary.

a. What is the correct real discount rate for cash flows from developed wells?