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 prices and costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10 percent per year, which is also the cost of capital. (Ignore taxes). Calculate the NPV to invest today.

Question

Quizplus · Accepted Answer

The NPV can be calculated using the formula for a perpetuity: NPV = (Cash Flow / Cost of Capital) - Initial Investment. Here, the annual cash flow is (Price - Extraction Cost) * Quantity = ($100 - $50) * 1,200,000 = $50 * 1,200,000 = $60,000,000. Using the cost of capital of 10%, NPV = ($60,000,000 / 0.10) - $500,000,000 = $600,000,000 - $500,000,000 = $100,000,000.