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Question 1. Suppose a firm uses its company cost of capital to evaluate all of its projects. Will it underestimate or overestimate the NPV of new projects that are riskier than the firm's average projects?

Question 1. Suppose a firm uses its company cost of capital to evaluate all of its projects. Will it underestimate or overestimate the NPV of new projects that are riskier than the firm's average projects?

Essentials Of Investments
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
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Question 1. Suppose a firm uses its company cost of capital to evaluate all of its projects. Will it underestimate or overestimate the NPV of new projects that are riskier than the firm's average projects? Question 2. An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40% of new wells which strike oil produce only 1,000 barrels a day; 60% produce 5,000 barrels a day. (a) Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $100 per barrel. (b) A geologist proposes to discount the cash flows of the new wells at 30 % to offset the risk of dry holes. The oil company's normal cost of capital is 10%. Does this proposal make sense? Explain briefly why or why not.
Transcribed Image Text:Question 1. Suppose a firm uses its company cost of capital to evaluate all of its projects. Will it underestimate or overestimate the NPV of new projects that are riskier than the firm's average projects? Question 2. An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40% of new wells which strike oil produce only 1,000 barrels a day; 60% produce 5,000 barrels a day. (a) Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $100 per barrel. (b) A geologist proposes to discount the cash flows of the new wells at 30 % to offset the risk of dry holes. The oil company's normal cost of capital is 10%. Does this proposal make sense? Explain briefly why or why not.
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