Read the following scenario, and answer the questions below.

As an economist, you are asked to analyze the present versus future value of fossil fuel resources in a newly discovered oil field. You determine that the oil which would take 1 year to extract) is estimated to be worth $10 million in today's market.

-You are asked to advise whether to immediately begin extracting the oil or wait 5 years to begin extraction.If the annual interest rate is 5%,at least how much would the oil have to be worth in the future market for you to advise waiting 5 years to begin extraction? Assume that you are asked to base your recommendation solely on the money earned.
A)Approximately $20 million
B)Approximately $10.5 million
C)Approximately $13 million
D)Approximately $12 million

Question

Read the following scenario, and answer the questions below.

As an economist, you are asked to analyze the present versus future value of fossil fuel resources in a newly discovered oil field. You determine that the oil which would take 1 year to extract) is estimated to be worth $10 million in today's market.

-You are asked to advise whether to immediately begin extracting the oil or wait 5 years to begin extraction.If the annual interest rate is 5%,at least how much would the oil have to be worth in the future market for you to advise waiting 5 years to begin extraction? Assume that you are asked to base your recommendation solely on the money earned.
A)Approximately $20 million
B)Approximately $10.5 million
C)Approximately $13 million
D)Approximately $12 million

Quizplus · Accepted Answer

To determine whether it is better to immediately begin extracting the oil or wait 5 years, we need to compare the present value of the oil if extracted immediately versus the present value of the oil if we wait 5 years and earn interest on the oil reserves until then.

Let X be the value of the oil in year 5. The present value of X, using a discount rate of 5%, is X / (1.05)^5.

If we wait 5 years to begin extraction, we will earn interest on the oil reserves during that time. The present value of the oil reserves, assuming they grow at a rate of 5% per year, is (1.05)^5 times the value of the oil reserves today.

Therefore, we should wait 5 years if:

X / (1.05)^5 > 1.05 * C

where C is the current value of the oil reserves.

Simplifying this inequality, we get:

X > 1.05^6 * C

If we assume that C is $10 million, then we get:

X > 1.05^6 * $10 million = $13.38 million

Therefore, we should advise waiting 5 years to begin extraction if the oil will be worth at least $13 million in the future market. Choice C is the nearest option to this value.

Read the Following Scenario, and Answer the Questions Below