The Jones Family, Incorporated The Scene: Early evening in an ordinary family ro
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The Jones Family, Incorporated
The Scene: Early evening in an ordinary family room in Manhattan. Modern furniture, with old copies of The Wall Street Journal and the Financial Times scattered around. Autographed photos of Alan Greenspan and George Soros are prominently displayed. A picture widow reveals a distant view of light on the Hudson River. John Jones sits at a computer terminal, glumly sipping a glass of chardonnay and putting on a carry trade in Japanese yen over the Internet. His wife Marsha enters.
Marsha: John, what’s wrong? Have you been selling yen again? That’s been losing trade for weeks.
John: Well, yes. I shouldn’t have gone to Goldman Sach’s foreign exchange brunch. But I’ve got to get out of the house somehow. I’m cooped up here all day calculating covariances and efficient risk-return trade-offs while you’re out trading commodity futures. You get all the glamour and excitement.
Marsha: Don’t worry, dear, it will be over soon. We only recalculate our most efficient common stock portfolio once a quarter. Then you can go back to leveraged leases.
John: You trade, and I do all the worrying. Now there’s a rumor that our leasing company is going to get a hostile takeover bid. I knew the debt ratio was too low, and you forgot to put on the poison pill. And you’ve made a negative-NPV investment!
Marsha: What investment?
John: That wildcat oil well. Another well in that old Sourdough field. It’s going to cost $5 million! Is there any oil down there?
Marsha: That Sourdough field has been good to us, John. Where do you think we got the capital for your yen trades? I bet we’ll find oil. Our geologist says there’s only a 30% chance of a dry hole.
John: Even if we hit oil, I bet we’ll only get 75 barrels of crude oil per day.
Marsha: That’s 75 barrels day in, day out. There are 365 days in a year, dear.
Johnny and Marsha’s teenage son Johnny bursts into the room.
Johnny: Hi, Dad! Hi, Mom! Guess what? I’ve made the junior varsity derivatives team! That means I can go on the field trip to the Chicago Board Options Exchange. (Pauses.) What’s wrong?
John: Your mother has made another negative-NPV investment. A wildcat oil well, way up on the North Slope of Alaska.
Johnny: That’s O.K, Dad. Mom told me about it. I was going to do an NPV calculation yesterday, but I had to finish calculating the junk-bond default probabilities for my corporate finance homework. (Grabs a financial calculator from his backpack.) Let’s see: 75 barrels a day times 365 days per year times $100 per barrel when delivered in Los Angeles… that’s $2.7 million per year.
John: That’s $2.7 million next year, assuming that we find any oil at all. The production will start declining by 5% every year. And we still have to pay $20 per barrel in pipeline and tanker charges to ship the oil from North Slope to Los Angeles. We’ve got some serious operating leverage here.
Marsha: On the other hand, our energy consultants project increasing oil prices. If they increase with inflation, price per barrel should increase by roughly 2.5% per year. The wells ought to be able to keep pumping for at least 15 years.
Johnny: I’ll calculate NPV after I finish with the default probabilities. The interest rate is 6%. Is it OK if I work with the beta of .8 and our usual figure of 7% for the market risk premium?
Marsha: I guess so, Johnny. But I am concerned about the fixed shipping costs.
John: (Takes a deep breath and stands up.) Anyway, how about a nice family dinner? I’ve reserved our usual table at the Four Seasons.
Everyone exits.
Announcer: It’s the wildcat well really negative-NPV? Will John and Marsha have to fight a hostile takeover? Will Johnny’s derivatives team use Black-Scholes or the binominal method? Fin out in the next episode of The Johns Family, Incorporated.
Questions:
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. How long does production have to continue for the well to be positive-NPV investment? Ignore taxes and other possible complications.
Hints:
Assume that the risk free interest rate = 6%, production starts today but sold at the end of the year, oil production will start declining by 5% after the first year, the inflation of oil prices and transportation cost start immediately and the life of the oil well is 15 years starting from today (day of investment).
Explanation / Answer
(Note: if 30% of probability that there is a dry hole, then there will be 70% of probability that there will be no dry hole. First NPV calculated without the probability consideration. To reflect the probability factor of success of "no dry hole", need to multiply NPV with 70%; Earlier answer was taken with 65% probability)
Wildcat oil well Days in year 365 Initial Fixed capital investment -5,000,000 Life 15 years Chances of dry hole 35% Production (barrels per day - bpd) 75 bpd Production declines every year by 5% Shipping charges 20 per barrel increase in Sales price per barrel (p.a) 2.50% p.a risk free rate 6% risk premium 7% beta 0.9 cost of eqiuty 12.30% (discount factor to calculate NPV) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Barrels produced p.a (sales decline by 5%p.a) 27,375 26,006 24,706 23,471 22,297 21,182 20,123 19,117 18,161 17,253 16,390 15,571 14,792 14,053 13,350 Price per barrel increases by 2.5% p.a $100 $102.50 $105.06 $107.69 $110.38 $113.14 $115.97 $118.87 $121.84 $124.89 $128.01 $131.21 $134.49 $137.85 $141.30 Sales in $ per annum $2,737,500 $2,665,641 $2,595,668 $2,527,531 $2,461,184 $2,396,578 $2,333,667 $2,272,409 $2,212,758 $2,154,673 $2,098,113 $2,043,037 $1,989,408 $1,937,186 $1,886,335 Total Shipping charges p.a ($20 per barrel) 547,500 520,125 494,119 469,413 445,942 423,645 402,463 382,340 363,223 345,062 327,808 311,418 295,847 281,055 267,002 Gross profit (5,000,000) $2,190,000 $2,145,516 $2,101,549 $2,058,118 $2,015,241 $1,972,932 $1,931,205 $1,890,069 $1,849,535 $1,809,611 $1,770,304 $1,731,619 $1,693,560 $1,656,131 $1,619,332 70% chance of no dry hole NPV Expected NPV over 2 years ($1,200,891.04) ($840,623.7) over 5 years $2,277,510.91 $1,594,258 over 15 years $7,368,025.91 $5,157,618 Production has to continue minimum for 3 years for positive NPVRelated Questions
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