Calculate Expected NPV for minimum ROR 12% on buying and drilling an oil lease w

Question

Calculate Expected NPV for minimum ROR 12% 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 10 years (from year 2 to year 12) or 40% probability that well yields annual income of 60,000 dollars for 5 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

Cash flows Rate of return 12% probability that hole is dry 70% Year 0 Year 1 -150000 -300000 dry hole @70% probability -35000 PV@12% -150000 -299107 Discounted cost -449107.14 2 3 4 5 6 7 8 9 10 11 12 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 60% probability cashflow 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 PV ofcashflow@12% 79719.39 71178.02 63551.81 56742.69 50663.11 45234.92 40388.32 36061 32197.32 28747.61 25667.51 PV*60%PROBABILITY 47831.63 42706.81 38131.08 34045.61 30397.87 27140.95 24232.99 21636.6 19318.39 17248.57 15400.51 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 40 % ptobability cashflow 60000 60000 60000 60000 60000 60000 PV ofcashflow@12% 47831.63 42706.81 38131.08 34045.61 30397.87 27140.95 PV*40%PROBABILITY 19132.65 17082.73 15252.43 13618.24 12159.15 10856.38 NPV PV*60%PROBABILITY + PV*40%PROBABILITY -42,914.53 66964.29 59789.54 53383.52 47663.86 42557.01 37997.33 24232.99 21636.6 19318.39 17248.57 15400.51 The project should not be taken by the company as it yields negative NPV with both 60% and 40% probability values

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