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The NPV

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A. Calculate the NPV of the wildcat oil well, taking account of the probability of a dry hole, the shipping costs, the decline in production, and the forecasted increase in oil prices.

b. How long does production have to continue for the well to be a positive NPV investment? How did you figure out your answer, i.e., what approach did you take?

c. What is the "break even" discount rate for the base case? How did you calculate it, or deduce it from using the model?

d. How likely does "success" with the wildcat well need to be to make the project acceptable at a 15% discount rate?

Use the dynamic graph to figure this out by changing the dry hole probability. How does the graph change to tell you the answer?

e. Now consider operating leverage, which is caused by fixed costs. If shipping costs are really fixed, then they are less volatile than the revenues which are discounted at the cost of capital.

Recalculate NPV, discounting shipping costs at the Jones Family's LT borrowing rate of 7% which the Jones Family enjoys due to its excellent credit rating.

What is the direction of change in NPV? Does that seem reasonable, given why shipping costs are being differentially discounted? Why or why not?

f. What happens to NPV as Beta increases? Explain why this happens, both in mathematical and financial terms.

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Calculating Negative NPV is highlighted.

Solution provided by:
Jayant Kumar, MBA
Education
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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