PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 9, Problem 25PS
Fudge factors An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2 million for 15 years. These are real (inflation-adjusted) cash flows.
The beta for producing wells is .9. The market risk premium is 8%, the nominal risk-free interest rate is 6%, and expected inflation is 4%.
The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 20% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10 million investment.
Ignore taxes and make further assumptions as necessary.
- a. What is the correct real discount rate for cash flows from developed wells?
- b. The oil company executive proposes to add 20 percentage points to the real discount rate to offset the risk of a dry hole. Calculate the
NPV of each well with this adjusted discount rate. - c. What do you say the NPYs of the two wells are?
- d. Is there any single fudge factor that could be added to the discount rate for developed wells that would yield the correct NPY for both wells? Explain.
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An oil company executive is considering investing $11.1 million in one or both of two wells: well 1 is expected to produce oil worth $3.11 million a year for 10 years; well 2 is expected to produce $2.11 million for 15 years. These are real (inflation-adjusted) cash flows.The beta for producing wells is 0.88. The market risk premium is 6%, the nominal risk-free interest rate is 7%, and expected inflation is 2%.The two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 18% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $11.1 million investment.Ignore taxes and make further assumptions as necessary.a. What is the correct real discount rate for cash flows from developed wells? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
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Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on
projects of this risk class is 9 percent, and that the maximum allowable payback and discounted payback statistics for the
project are 2.0 and 3.0 years, respectively.
Time:
0
1
2
3
4
5
6
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$1,560
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Use the Pl decision rule to evaluate this project. (Do not round intermediate calculations and round your final answer to 2
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O rejected
O accepted
1. A company is considering investing in a project. The future perpetual cash flow is either $750K if the market goes up or $125K if the market goes down next year. The objective probability the market will go up is 20%. The appropriate risk-adjusted rate of return (cost of capital) is 25%. The initial capital investment required at time 0 is $1200K.
а. Should the company invest in this project?
b. Upon closer inspection the CFO realizes the company actually has some flexibility in managing this project. Specifically, if the market goes down, the company can abandon the project, and liquidate its original capital investment for 75% of its original value. If, however, the market should go up, the company could expand operations, which would result in twice the original PV of the cash flows. To expand the company will have to make an additional capital expenditure of $800K. The CFO wants to know if the company should now proceed with the project with the added flexibilities, and asks…
Chapter 9 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 9 - (VAR.P and STDEV.P) Choose two well-known stocks...Ch. 9 - (AVERAGE, VAR.P and STDEV.P) Now calculate the...Ch. 9 - (SLOPE) Download the Standard Poors index for the...Ch. 9 - Definitions Define the following terms: a. Cost of...Ch. 9 - True/false True or false? a. The company cost of...Ch. 9 - Company cost of capital Quark Productions (Give...Ch. 9 - Company cost of capital The total market value of...Ch. 9 - Company cost of capital You are given the...Ch. 9 - Company cost of capital Nero Violins has the...Ch. 9 - WACC A company is 40% financed by risk-free debt....
Ch. 9 - WACC Binomial Tree Farms financing includes 5...Ch. 9 - Prob. 10PSCh. 9 - Measuring risk The following table shows estimates...Ch. 9 - Prob. 12PSCh. 9 - Asset betas Which of these projects is likely to...Ch. 9 - Asset betas EZCUBE Corp. is 50% financed with...Ch. 9 - Prob. 15PSCh. 9 - Prob. 16PSCh. 9 - Prob. 17PSCh. 9 - Fudge factors John Barleycorn estimates his firms...Ch. 9 - Prob. 19PSCh. 9 - Prob. 20PSCh. 9 - Certainty equivalents A project has a forecasted...Ch. 9 - Certainty equivalents A project has the following...Ch. 9 - Prob. 23PSCh. 9 - Beta of costs Suppose that you are valuing a...Ch. 9 - Fudge factors An oil company executive is...
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