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What is the correct real discount rate for cash flows

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Question - An oil company executive is considering investing $11.0 million in one or both of two wells: well 1 is expected to produce oil worth $3.1 million a year for 10 years; well 2 is expected to produce $2.1 million for 15 years. These are real (inflation-adjusted) cash flows.

The beta for producing wells is 0.89. The market risk premium is 7%, the nominal risk-free interest rate is 6%, and expected inflation is 5%.

The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 19% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $11.0 million investment.

Ignore taxes and make further assumptions as necessary.

Required -

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. 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.

Reference no: EM133031884

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