Suppose an oil company is considering whether to develop production facilities for a newly discovered oil field on lands owned by a state government. Â If the firm spends $2 billion in present value in capital costs, it could install facilities capable of producing 80,000 barrels per day. Annual operating costs for the oil field are anticipated to be $30 per barrel produced. The company expects production from the field to start at 80,000 barrels per day but then decline at 9 percent annually indefinitely. The firm has to pay its investors a 10 percent annual return.
The firm's managers are risk-averse, and decide to make their investment decisions based not on the anticipated oil price, but rather on profits that would result if the oil price were $50 per barrel. Would the company decide to make the investment?