PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 9, Problem 25PS
Fudge factors An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2 million for 15 years. These are real (inflation-adjusted) cash flows.
The beta for producing wells is .9. The market risk premium is 8%, the nominal risk-free interest rate is 6%, and expected inflation is 4%.
The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 20% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10 million investment.
Ignore taxes and make further assumptions as necessary.
- a. What is the correct real discount rate for cash flows from developed wells?
- 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. - c. What do you say the NPYs of the two wells are?
- d. Is there any single fudge factor that could be added to the discount rate for developed wells that would yield the correct NPY for both wells? Explain.
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Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on
projects of this risk class is 9 percent, and that the maximum allowable payback and discounted payback statistics for the
project are 2.0 and 3.0 years, respectively.
Time:
0
1
2
3
4
5
6
Cash flow:
-$7,300 $1,160 $2,360 $1,560
$1,560
$1,360
$1,160
Use the Pl decision rule to evaluate this project. (Do not round intermediate calculations and round your final answer to 2
decimal places.)
PI
0.94
Should it be accepted or rejected?
O rejected
O accepted
Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 2.0 and 3.0 years, respectively.
Time:
0
1
2
3
4
5
6
Cash flow:
−$7,500
$1,180
$2,380
$1,580
$1,580
$1,380
$1,180
Use the NPV decision rule to evaluate this project. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places.)
NPV: ?
Should it be accepted or rejected?multiple choice
accepted
rejected
Chapter 9 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 9 - (VAR.P and STDEV.P) Choose two well-known stocks...Ch. 9 - (AVERAGE, VAR.P and STDEV.P) Now calculate the...Ch. 9 - (SLOPE) Download the Standard Poors index for the...Ch. 9 - Definitions Define the following terms: a. Cost of...Ch. 9 - True/false True or false? a. The company cost of...Ch. 9 - Company cost of capital Quark Productions (Give...Ch. 9 - Company cost of capital The total market value of...Ch. 9 - Company cost of capital You are given the...Ch. 9 - Company cost of capital Nero Violins has the...Ch. 9 - WACC A company is 40% financed by risk-free debt....
Ch. 9 - WACC Binomial Tree Farms financing includes 5...Ch. 9 - Prob. 10PSCh. 9 - Measuring risk The following table shows estimates...Ch. 9 - Prob. 12PSCh. 9 - Asset betas Which of these projects is likely to...Ch. 9 - Asset betas EZCUBE Corp. is 50% financed with...Ch. 9 - Prob. 15PSCh. 9 - Prob. 16PSCh. 9 - Prob. 17PSCh. 9 - Fudge factors John Barleycorn estimates his firms...Ch. 9 - Prob. 19PSCh. 9 - Prob. 20PSCh. 9 - Certainty equivalents A project has a forecasted...Ch. 9 - Certainty equivalents A project has the following...Ch. 9 - Prob. 23PSCh. 9 - Beta of costs Suppose that you are valuing a...Ch. 9 - Fudge factors An oil company executive is...
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