Question
please answer and show all parts An oil company owns an oil field which can produce 1 million barrels of oil in total. The production
please answer and show all parts
An oil company owns an oil field which can produce 1 million barrels of oil in total. The production cost is $50 per barrel. The oil price is $40 per barrel now. It will either increase to $61 per barrel or decrease to $26 per barrel next year, with equal likelihood, and will grow at 2% per year perpetually. The risk-free rate is 2%. (Here, the price and risk-free rate are all in real terms.) The oil price risk is not diversifiable. The company can either extract oil now (year 0) or next year (year 1). It can also decide to abandon the field at no cost.
A) What is the NPV of this oil field if the company extracts the oil now?
B) What is the NPV of the oil field under the optimal production/abandonment strategy?
C) If the company does not have the abandonment option, it must produce oil either now (year 0) or next year (year 1), regardless of the oil price. What would be the value of the field in this case (i.e., without the abandonment option)?
D) How much is the abandonment option of the oil field worth? Note: The value of the abandonment option is defined by: abandonment option=NPV (optimal production/abandonment strat)- NPV (without abandonment option)
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started