The Beta for a producing well is 0.7. The market risk premium is 7.5%, and the risk-free-rate is 3.6%. For simplicity assume there are no taxes and make further assumptions as necessary. a. What is the correct discount rate for cash flows from the developed wells? b. What is the NPV of the cash flows from the well if you are guaranteed to strike oil (i.e., ignoring the risk of a dry hole)? Construct a pro forma to show your answer. c. The oil company executive proposes to add 20 percentage points to the discount rate to offset the risk of a dry hole. He calls this a "fudge factor." Calculate the NPV of the well with this adjusted discount rate. d. What do you say the NPV of the well is? Is it your answer from b or your answer from c, or something else? Why? If it is something else, please calculate it here.
The Beta for a producing well is 0.7. The market risk premium is 7.5%, and the risk-free-rate is 3.6%. For simplicity assume there are no taxes and make further assumptions as necessary. a. What is the correct discount rate for cash flows from the developed wells? b. What is the NPV of the cash flows from the well if you are guaranteed to strike oil (i.e., ignoring the risk of a dry hole)? Construct a pro forma to show your answer. c. The oil company executive proposes to add 20 percentage points to the discount rate to offset the risk of a dry hole. He calls this a "fudge factor." Calculate the NPV of the well with this adjusted discount rate. d. What do you say the NPV of the well is? Is it your answer from b or your answer from c, or something else? Why? If it is something else, please calculate it here.
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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Transcribed Image Text:1) An oil company is drilling a series of new wells that are adjacent to an existing oil field. About 20% of
the new wells will be dry holes and will produce zero oil. If the wells do, in fact, strike oil, they have
different expected values. Well One is expected to produce oil worth $5 million per year for 10 years if
it strikes oil.
The well will cost $10 million apiece to drill. This is depreciable over the life of the project. It requires
an investment of $2 million in Net Working Capital, which you will get back in the end. There are $1
million in expenses each year on maintenance and other operating expenses. There is no salvage value.
The Beta for a producing well is 0.7. The market risk premium is 7.5%, and the risk-free-rate is 3.6%. For
simplicity assume there are no taxes and make further assumptions as necessary.
a. What is the correct discount rate for cash flows from the developed wells?
b. What is the NPV of the cash flows from the well if you are guaranteed to strike oil (i.e.,
ignoring the risk of a dry hole)? Construct a pro forma to show your answer.
C. The oil company executive proposes to add 20 percentage points to the discount rate to
offset the risk of a dry hole. He calls this a "fudge factor." Calculate the NPV of the well
with this adjusted discount rate.
d. What do you say the NPV of the well is? Is it your answer from b or your answer from c,
or something else? Why? If it is something else, please calculate it here.
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