Calculate Expected NPV for minimum ROR 14% on buying and drilling an oil lease w

Question

Calculate Expected NPV for minimum ROR 14% 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

Scenario 1 : Drilling Fails Probability   70% Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Lease Cost      (150,000) Drilling Cost       (300,000) Abandonment cost         (50,000) Net Cash Flow    (150,000)     (350,000)                  -                     -                     -                      -                    -                  -                     -                   -                   -                  -   PV Factor @14%           1.0000         0.8772 PV of Net Outflow    (150,000)     (307,018)                  -                     -   NPV =    (457,018) Scenario 1 : Drilling Succeeds : Situation 1 Probability   60% Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Lease Cost      (150,000) Drilling Cost       (300,000) Annual Income        100,000       100,000       100,000         100,000      100,000    100,000       100,000     100,000     100,000    100,000       100,000 Net Cash Flow    (150,000)     (300,000)      100,000       100,000       100,000         100,000      100,000    100,000       100,000     100,000     100,000    100,000       100,000 PV Factor @14%           1.0000         0.8772         0.7695         0.6750          0.5921           0.5194         0.4556      0.3996          0.3506       0.3075        0.2697      0.2366         0.2076 PV of Net Outflow    (150,000)     (263,158)         76,947         67,497          59,208           51,937         45,559      39,964          35,056       30,751        26,974      23,662         20,756 NPV =         65,152 Scenario 1 : Drilling Succeeds : Situation 2 Probability   40% Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Lease Cost      (150,000) Drilling Cost       (300,000) Annual Income           60,000         60,000          60,000           60,000         60,000      60,000 Net Cash Flow    (150,000)     (300,000)         60,000         60,000          60,000           60,000         60,000      60,000                   -                   -                   -                  -   PV Factor @14%           1.0000         0.8772         0.7695         0.6750          0.5921           0.5194         0.4556      0.3996          0.3506       0.3075        0.2697      0.2366 PV of Net Outflow    (150,000)     (263,158)         46,168         40,498          35,525           31,162         27,335      23,978                   -                   -                   -                  -   NPV =    (208,491) So Scenario ofSuccessful Drilling Situation                   1                    2 Total Sub Probability 60% 40% NPV           65,152     (208,491) Expected NPV           39,091       (83,396)      (44,305) Total Scenario Probability NPV Wtd Probability Drilling Fail   70%     (457,018)    (319,912) Drilling Successful 30%       (44,305)      (13,292) Total    (333,204)

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