An oil company is drilling a series of new wells on the perimeter of a...
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An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40% of new wells which strike oil produce only 1,000 barrels a day; 60% produce 5,000 barrels a day. (a) Forecast the annual revenues from a new perimeter well. Use a future oil price of $100 per barrel. (b) A geologist proposes to discount the cash flows of the new wells at 30% to offset the risk of drilling but not finding oil. The oil company's normal cost of capital is 10%. Does this proposal make sense? Explain briefly why or why not
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