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Homework answers / question archive / Your firm's geologists have discovered a small oil field in New York's Westchester County

Your firm's geologists have discovered a small oil field in New York's Westchester County

Finance

Your firm's geologists have discovered a small oil field in New York's Westchester County. The field is forecasted to produce its first cash flow exactly one year from today of $3 million. You estimate the beta of a similar investment is 1.25. The expected return on the market is 10%, and the risk-free rate is 2%.

 

Your job is to determine the present value of the expected cash flows. Your answer, of course, depends on what happens to the cash flows after the first year. Calculate the present value for the following cases:

 

 

Question 28

The cash flows are forecasted to continue forever, with no expected growth or decline?

 

 

 

Question 29

The cashflows are forecasted to continue for 20 years only, with no expected growth or decline during that period?

 

 

 

Question 30

The cashflows are forecasted to continue forever, increasing by 2% per year because of inflation?

 

 

 

Question 31

The cash flows are forecasted to continue for 20 years only, increasing by 2% per year because of inflation?

 

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First we calculate Discount Rate using CAPM:

Discount Rate = Risk-free Rate + Beta*(Market Rate of Return - Risk-free Rate)

= 2% + 1.25*(10%-2%)

= 2% + 1.25*8% 

= 2% + 10%

Discount Rate = 12%

 

Question 28

The cash flows are forecasted to continue forever, with no expected growth or decline?

Present Value = Cash Flows / Discount Rate

= $3,000,000/12%

Present Value = $25,000,000

 

Question 29

The cashflows are forecasted to continue for 20 years only, with no expected growth or decline during that period?

Present Value = Annual Cash Flows * PVIF @12% for 20 Years 

= $3,000,000*7.469444

Present Value = $22,408,330.87

 

 

Question 30

The cashflows are forecasted to continue forever, increasing by 2% per year because of inflation?

Present Value = Cash Flows/(Discount Rate - Growth Rate)

= $3,000,000/(12%-2%)

= $3,000,000/10%

Present Value = $30,000,000

 

 

Question 31

The cash flows are forecasted to continue for 20 years only, increasing by 2% per year because of inflation?

Present Value = Cash Flow* (((1+r)^n-(1+g)^n)/((1+r)^n*(r-g))
 

= $3,000,000*(((1+12%)^20-(1+2%)^20)/((1+12%)^20*(12%-2%))

= $3,000,000*8.459566

Present Value = $25,378,699.21

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