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. The beta for producing wells is 0.9. The

market risk premium is 7%, and the nominal risk-free interest rate is 2%. 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 discount rate for cash flows from developed wells?

b. The oil company executive proposes to add 20 percentage points to the 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. Why is it wrong to use a single fudge factor added to the discount rate for

developed wells? Explain.