Problem:
An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20 % of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40 % of new wells which strike oil produce only 1,000 barrels a day; 60 % produce 5,000 barrels a day.
Required:
Question 1: Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $100 per barrel.
Question 2: A geologist proposes to discount the cash flows of the new wells at 30 % to offset the risk of dry holes. The oil company's normal cost of capital is 10 %. Does this proposal make sense? Explain briefly why or why not.
Note: Please show the work not just the answer.