An oil company executive is considering investing $10 million in one or both of two well" 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?

b. The oil company executive proposes to add 20 percentage points to the real discount rate to offset the risk of a dry hole. Calculate the NPV of each well with this adjusted discount rate.

c. What do you say the NPVs of the two wells are?

d. Is there any single fudge factor that could be added to the discount rate for developed wells that would yield the correct NPV for both wells? Explain?

Answers

24A) Since the risk of a dry hole is unlikely to be market-related, we can use the same discount rate as for producing wells. Thus, using the Security Market Line:

r_nominal = 0.06 + (0.9 0.08) = 0.132 = 13.2%

We know that:

(1 + r_nominal) = (1 + r_real) (1 + r_inflation)

Therefore: r real = 1.132/1.04 - 1= .0.0885 = 8.885%

My question is the following: How would you complete the answers to section 24B = Well 1 NPV -425,800 and Well 2 NPV -3,222,800 and 24C Well 1 NPV 5,504,00 and Well 2 NPV 3,012,000 using the excel spreadsheet formula for NPV.

When I complete the formula using excel, I would probably have the right answers if I could round up. The answers I got for 24B were: Well 1 NPV -425,774 and Well 2 NPV 3,222,336.