Question

Canyon Buff Enterprise is considering drilling a new self sustaining oil well at a cost of $800,000. This well will produce $100,000 worth of oil during the first year, but as oil is removed from the well the amount of oil produced will decline by 2%, per year forever. If the interest rate is 8%, then the NPV of this oil well is closest to:

A. $250,000

B. -$250,000

C. $0

D. cannot be determined

E. $200,000

Answer 1

NPV :
NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.
PV of Cash inflows = CF1 / [ Ke - g ]

CF1 = cash flow at year 1

Ke = Required rate

g = Growth rate

= $ 100000 / [ 8% - (-2%) ]

= $ 100000 / [ 8% + 2% ]

= $ 100000 / 10%

= $ 1000000

NPV = PV of Cash Inflows - PV of cash outflows

= $1000000 - $ 800000

= $ 200000

Option E is correct.