Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year, which is also the cost of capital (Ignore
Taxes). Calculate the NPV to invest today.

Question

Quizplus · Accepted Answer

The NPV is calculated as the present value of perpetual cash flows minus the initial investment. The annual cash flow is (Price - Cost) * Quantity = ($50 - $20) * 200,000 = $6,000,000. The present value of a perpetuity is Cash Flow / Discount Rate = $6,000,000 / 0.10 = $60,000,000. NPV = $60,000,000 - $50,000,000 = $10,000,000.