QUESTIONS
1.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 a positive-NPV investment? Ignore taxes and other possible complications.
2.Now consider operating leverage. How should the shipping costs be valued, assuming that output is known and the costs are fixed? How would your answer change if the shipping costs were proportional to output? Assume that unexpected fluctuations in output are zerobeta and diversifiable. (Hint: The Jones’s oil company has an excellent credit rating. Its long-term borrowing rate is only 7%.)
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