Question

You are investigating the possibility of investing in a productive oil well that is expected to produce 2,500 barrels of oil per year for 5 years. The current price of oil is $70 per barrel, but the price is expected to increase at a constant rate of 3 percent per year for the next 5 years. If your opportunity cost of funds is 13.50 percent p.a., what would be the upper limit of how much you would be willing to invest in this oil well? Please show calculations!

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J	K
2
3		The maximum amount to be invested in the well will be the present value of future cash flows from the well.
4
5		Number of Barrels produced per year	2500
6		Number of Years	5
7		Current Price of Oil	70
8		Increase in price per year	0.03
9		Cost of capital	0.135
10
11		Year	0	1	2	3	4	5
12		Number of Barrels Produced		=$D$5	=$D$5	=$D$5	=$D$5	=$D$5
13		Price of Oil	=D7	=D13*(1+$D$8)	=E13*(1+$D$8)	=F13*(1+$D$8)	=G13*(1+$D$8)	=H13*(1+$D$8)
14		Cash Flow from Well (FCF)		=E12*E13	=F12*F13	=G12*G13	=H12*H13	=I12*I13	=I12*I13
15		Cost of capital	=D9
16		(P/F,i,n) for each year		=1/((1+$D15)^E11)	=1/((1+$D15)^F11)	=1/((1+$D15)^G11)	=1/((1+$D15)^H11)	=1/((1+$D15)^I11)	=1/((1+$D15)^I11)
17		Present Value of cash flows = FCF*(P/F,i,n)		=E14*E16	=F14*F16	=G14*G16	=H14*H16	=I14*I16
18		Present value of future cash flows	=SUM(E17:I17)	=SUM(E17:I17)
19
20		Hence maximum amount to be invested	=D18
21