Calculate Expected NPV for minimum ROR 10% on buying and drilling an oil lease w

Question

Calculate Expected NPV for minimum ROR 10% on buying and drilling an oil lease with these estimated costs: The lease costs 150,000 dollars at time zero and drilling will start at year 1 with the cost of 300,000 dollars. There is 70% that well is a dry hole without any production and abandonment cost of 50,000 dollars will be incurred at year 1. If drilling is successful and well is a producer, then there are two possibilities: 60% probability that well yields annual income of 100,000 dollars for 11 years (from year 2 to year 12) or 40% probability that well yields annual income of 60,000 dollars for 6 years (from year 2 to year 7). Is this investment economically satisfactory? Explain your work in detail including all the required equations and calculations.

Explanation / Answer

As given in the question there is a 70% probability that the well is a dry hole. If the drilling is successful(probability 30%) then there are again two cases.

First there is the lease of 150000.

Then drilling cost of $300000. The present value of that will be =300000/1.1 = 272727.27

If the well is a dry hole then the present value of the abandoment cost will be = 50000/1.1 =45454.54

If the drilling is successful we have two cases:

Firstly annual income of 100000 from year 2 to 12 (60%) chance

Year 2

Second, annual income of 60000 from year 2 to 7 (40%) chance

Year 2

Now lets calculate the profitablility of the operations= 70%*-45454.54+30%*(60%*590460.1+40%*237559,7)

= 102971.80

But if we include the lease cost and the drilling cost, the expenses will be way over the profit generated by the operations.

Therefore it is not a viable investment.

Years Present value of income

Year 2

100000/1.12 = 82644.63 Year 3 100000/1.13 = 75131.48 Year 4 100000/1.14 =68301.35 Year 5 100000/1.15 = 62092.13 Year 6 100000/1.16 =56447.39 Year 7 100000/1.17 =51315.81 Year 8 100000/1.18 = 46650.74 Year 9 100000/1.19 = 42409.76 Year 10 100000/1.110 = 38554.33 Year 11 100000/1.111 = 35049.39 Year 12 100000/1.112 = 31863.08 Total 590460.1

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