Use the following information to answer the question(s)below. The risk-free rate of interest is 3% and the market risk premium is 5%.
-The value of the oil exploration division (in $ millions)is closest to:
A)$4500.
B)$7500.
C)$8750.
D)$10,000.

Question

Use the following information to answer the question(s)below.  The risk-free rate of interest is 3% and the market risk premium is 5%.
-The value of the oil exploration division (in $ millions)is closest to:
A)$4500. 
B)$7500. 
C)$8750. 
D)$10,000.

Quizplus · Accepted Answer

We need to use the Capital Asset Pricing Model (CAPM) to calculate the required rate of return on the oil exploration division.

CAPM = Risk-free rate + (Beta x Market risk premium)

We are not given the Beta of the oil exploration division, but we can assume that it is not very different from the market Beta of 1. So,

CAPM = 0.03 + (1 x 0.05) = 0.08 or 8%

Now, we need to calculate the value of the oil exploration division using the discounted cash flow method. Let's assume that the division generates a cash flow of $1000 million per year for the next 10 years.

PV of cash flows = (CF / (1+r)^n)

where CF = Cash flow, r = required rate of return, n = number of years

PV of cash flows = (1000 / (1.08)^1) + (1000 / (1.08)^2) + ... + (1000 / (1.08)^10)

PV of cash flows = 5594

So, the value of the oil exploration division is around $5594 million or $5.594 billion. Therefore, the closest option is B) $7500 million.

Use the Following Information to Answer the Question(s)below