An oil company is drilling a series of new wells on the perimeter of a producing oil field.
About 20 percent 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 percent of new wells that strike oil produce only 1,000 barrels a day; 60 percent produce 5,000 barrels per day.
a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $15 per barrel.
b. Ageologist proposes to discount the cash flows of the new wells at 30 percent to offset the risk of dry holes. The oil company's normal cost of capital is 10 percent. Does this proposal make sense? Briefly explain why or why not.