Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

1) An oil company is drilling a series of new wells that are adjacent to an existing oil field.About 20% of the new wells will

1) An oil company is drilling a series of new wells that are adjacent to an existing oil field.About 20% of the new wells will be dry holes and will produce zero oil.If the wells do, in fact, strike oil, they have different expected values.Well One is expected to produce oil worth $5 million per year for 10 years if it strikes oil.

The well will cost $10 million apiece to drill.This is depreciable over the life of the project.Itrequires an investment of $2 million in Net Working Capital, which you will get back in the end.There are $1 million in expenses each year on maintenance and other operating expenses.There is no salvage value.

The Beta for a producing well is 0.7.The market risk premium is 7.5%, and the risk-free-rate is 3.6%.For simplicity assume there are no taxes and make further assumptions as necessary.

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

b.What is the NPV of the cash flows from the well if you are guaranteed to strike oil (i.e., ignoring the risk of a dry hole)?Construct a pro forma to show your answer.

c.The oil company executive proposes to add 20 percentage points to the discount rate to offset the risk of a dry hole.He calls this a "fudge factor."Calculate the NPV of the well with this adjusted discount rate.

d.What do you say the NPV of the well is?Is it your answer from b or your answer from c, or something else?Why?If it is something else, please calculate it here.

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Analysis for Financial Management

Authors: Robert C. Higgins

10th edition

007803468X, 978-0078034688

More Books

Students also viewed these Finance questions

Question

What are the parameters in a simple linear regression model?

Answered: 1 week ago