Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

An oil company executive is considering investing $10.3 million in one or both of two wells: well 1 is expected to produce oil worth $3.03

An oil company executive is considering investing $10.3 million in one or both of two wells: well 1 is expected to produce oil worth $3.03 million a year for 10 years; well 2 is expected to produce $2.03 million for 15 years. These are real (inflation-adjusted) cash flows. The beta for producing wells is 0.93. The market risk premium is 6%, the nominal risk-free interest rate is 7%, and expected inflation is 2%. The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 23% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10.3 million investment. Ignore taxes and make further assumptions as necessary. a. What is the correct real discount rate for cash flows from developed wells? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

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. (Negative answers should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers in dollars not in millions and round your answers to the nearest whole dollar amount.)

c. Are the NPVs calculated in Part B the correct NPVs? If they are correct, re-enter the NPVs from your answers in Part B for both wells. If they are incorrect, re-calculate the NPVs to the correct values for both wells. (Do not round intermediate calculations. Enter your answers in dollars not in millions and round your answers to the nearest whole dollar amount.)

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

Principles Of Managerial Finance

Authors: Chad Zutter, Scott Smart

16th Global Edition

1292400641, 978-1292400648

More Books

Students also viewed these Finance questions