Petroleum Inc. (PI) controls offshore oil leases. It is considering the construc

Question

Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Calculate today's NPV of the project (i.e., NPV @ t = 0) if it were postponed by one year

Explanation / Answer

   Easiest to do computations in $M. NPV today = -500 + (1.2)(100 - 50)/0.10 = +100. •

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