An oil company executive is considering investing $11.1 million in one or both of two wells: well 1 is expected to produce oil worth $3.11 million a year for 10 years; well 2 is expected to produce $2.11 million for 15 years. These are real (inflation-adjusted) cash flows. The beta for producing wells is 0.88. 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 18% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $11.1 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.) NPV Well 1 Well 2 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? No Well 1 NPV Well 2 NPV
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
An oil company executive is considering investing $11.1 million in one or both of two wells: well 1 is expected to produce oil worth $3.11 million a year for 10 years; well 2 is expected to produce $2.11 million for 15 years. These are real (inflation-adjusted) cash flows.
The beta for producing wells is 0.88. 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 18% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $11.1 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.)
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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.)
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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.)
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