Petroleum Inc. (PI) controls offshore oil leases. It is considering the construc

Question

Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Calculate today's NPV of the project (i.e., NPV @ t = 0) if it were postponed by one year.

Explanation / Answer

Since the cash flows are forever, the problem relates to perpetuity.

The formula for present value of perpetuity is

Present value of perpetuity = Annual cash flows / Cost of capital

Annual cash flows = ( Selling price - Cost per bbl) x Number of bbl's per year

                             = ($100 / bbl - $50 / bbl) x $1,200,000

                             = $60,000,000 /bbl

Substitute the values in the above formula:

PV of perpertuity = $60,000,000 / 0.1

                            = $600,000,000

To calculate the NPV of the project,

NPV = Present value of perpetuity - Cost of the project

        = $600,000,000 - $500,000,000

       = $100,000,000

Therefore, the NPV of the project when t=0 is $100,000,000 or $100 million

Hence the correct option is A) $100,000,000

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