An oil company executive is considering investing $10.7 million in one or both of two wells: well 1 is expected to produce oil worth $3.07 million a year for 10 years; well 2 is expected to produce $2.07 million for 15 years. These are real (inflation-adjusted) cash flows. The beta for producing wells is 0.97. 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 27% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10.7 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.) Real discount rate 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.) Well 1 Well 2 NPV % 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.) Are the NPVs in Part B correct? Well 1 NPV Well 2 NPV
An oil company executive is considering investing $10.7 million in one or both of two wells: well 1 is expected to produce oil worth $3.07 million a year for 10 years; well 2 is expected to produce $2.07 million for 15 years. These are real (inflation-adjusted) cash flows. The beta for producing wells is 0.97. 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 27% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10.7 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.) Real discount rate 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.) Well 1 Well 2 NPV % 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.) Are the NPVs in Part B correct? Well 1 NPV Well 2 NPV
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
Please answer all parts.
Transcribed Image Text:An oil company executive is considering investing $10.7 million in one or both of two wells: well 1 is expected to produce oil worth
$3.07 million a year for 10 years; well 2 is expected to produce $2.07 million for 15 years. These are real (inflation-adjusted) cash flows.
The beta for producing wells is 0.97. 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 27% chance of a dry hole in each
case. A dry hole means zero cash flows and a complete loss of the $10.7 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.)
Real discount rate
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.)
Well 1
Well 2
NPV
%
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.)
Are the NPVs in Part B correct?
Well 1 NPV
Well 2 NPV
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