Question
Problem 1: NPV & PI. Louisiana Drilling and Exploration, Inc., (LD&E) has the funds necessary to complete one of two risky oil and gas drilling
Problem 1: NPV & PI. Louisiana Drilling and Exploration, Inc., (LD&E) has the funds necessary to complete one of two risky oil and gas drilling projects. The first, Permian Basin 1, involves the recovery of a well that was plugged and abandoned 5 years ago but that may now be profitable, given improved recovery techniques. The second, Permian Basin 2, is a new onshore exploratory well that appears to be especially promising. Based on a detailed analysis by its technical staff, LD&E projects a 10-year life for each well with annual net cash flows as follows:
Project Probability Annual Cash Flow ($)
Permian Basin 1
0.08 500,000
0.84 1,000,000
0.08 1,500,000
Permian Basin 2
0.18 300,000
0.64 900,000
0.18 1,500,000
In the recovery project valuation, LD&E uses an 8 per cent risk-fee rate and a standard 12 per cent risk premium. For exploratory drilling projects, the company uses larger risk premiums proportionate to project risks as measured by the project coefficient of variation. For example (and it is only an example), an exploratory project with a coefficient of variation 1 times that for recovery projects would require a risk premium of 18 per cent (= 1.5 X 12%). Both projects involve land acquisition as well as surface preparation and subsurface drilling costs of $3 million each.
A.Calculate the expected value, standard deviation, and coefficient of variation for annual net operating revenues from each well.
B.Calculate and evaluate the NPV for each project using the risk-adjusted discount rate method.
C.Calculate and evaluate the PI for each project.
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