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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. The beta for producing wells is 0.9. The market risk premium is 7%, and the nominal risk-free interest rate is 2%. 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 discount rate for cash flows from developed wells?
b. The oil company executive proposes to add 20 percentage points to the 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 NPVs of the two wells are?
d. Why is it wrong to use a single fudge factor added to the discount rate for developed wells? Explain.
Finance is about Gunns Ltd, a company in dealing with forestry products in Australia. The company has also been listed in Australian Stock Exchange. As many companies producing forestry products, even Gunns Ltd is facing various problems. Due to the ..
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