Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the

Question

Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $40 million (C0) and is expected to remain constant. The price of oil P is $40/bbl and the extraction costs are $25/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes). Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then expected NPV of the project if postponed by one year is: (approximately) Please show work. Thanks

A. +50 million

B. -20 million

C. +64 million

D. +59 million

Explanation / Answer

NPV(oil price = $60/bbl) = (60 - 25)(300,000)/0.06 - 50,000,000 = +125,000,000 NPV(oil price = $30/bbl) = (30- 25)(300,000)/0.06 - 50,000,000 = - 25,000,000 (reject) NPV(oil price = $30/bbl) = 0; (We only invest if the oilprice next year is $60/bbl) Expected NPV = [(0.5)(0) + (0.5)(125,000,000)]/1.06 = 62,500,000/1.06 = $59 million

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