Question

Use the following information to answer Questions 6 and 7.
The 1-, 2-, 3-, and 4-year oil forward prices are $60, $58.35, $57.40, and $55 per barrel, respectively. Your firm is thinking about starting up an offshore drilling station and needs to forecast revenue over the next 4 years. Assume the risk-free rate is 5.25% each year and initial costs are $150,000,000.
6. (1 point) If your firm expects to extract 1,100,000 barrels of oil per year and each barrel costs $11.50 to extract, then what is the net present value (NPV) of this project? Use continuous compounding. Round your answer to the nearest $0.01.
7. (0.50 points) Is this commodity market in contango or backwardation?

Answer 1

6.

Working Note :- Calculation of Profit per year	Total Barrels per year	1,100,000
Year	Price Per Barrel	Cost of Extraction per Barrel	Net Profit per Barrel	Total Profit
0	$                        -	$                                                   -	$                                     -	$                   -
1	$                 60.00	$                                            11.50	$                              48.50	$ 53,350,000
2	$                 58.35	$                                            11.50	$                              46.85	$ 51,535,000
3	$                 57.40	$                                            11.50	$                              45.90	$ 50,490,000
4	$                 55.00	$                                            11.50	$                              43.50	$ 47,850,000
Calculation of NPV
Year	Cash Flows	PVF@ 5.25%	Present Value
0	$ (150,000,000)	1	$        (150,000,000.00)
1	$       53,350,000	0.9501	$             50,687,835.00
2	$       51,535,000	0.9027	$             46,520,644.50
3	$       50,490,000	0.8577	$             43,305,273.00
4	$       47,850,000	0.8149	$             38,992,965.00
		NPV	$             29,506,717.50

7. Backwardation since the future prices are lower than the spot prices and continuously falling.