Question

An oil and gas exploration firm invested $ 2,400,000 in drilling for natural gas in a new gas field. The firm's geologist believes the field has the potential to produce gas for 25 years. The revenue resulting from the gas well the first year after drilling is $570,000; based on previous experiences with similar types of wells, it is expected the annual revenue will decrease at an annual rate of 2%. Likewise, the costs of operating the well the first year totals $ 120,000; costs are expected to increase at an annual rate of 4%. Based on a 25-year planning horizon and a MARR of 18%, what is the firm's external rate of return for the investment?

Answer 1

The question pertains to computing the external rate of return for an investment in a natural gas well by using the provided revenue decline rate, cost increase rate, and MARR over a 25-year period. Future cash flows have to be estimated considering these factors to calculate the ERR.

Step-by-step explanation:

The student's question concerns the calculation of the external rate of return (ERR) for an oil and gas exploration firm's investment in a natural gas well. The firm invested $2,400,000 and expects to produce gas for 25 years, with an initial annual revenue of $570,000 decreasing by 2% each year, and initial annual costs of $120,000 increasing by 4% each year. The firm is using a minimum attractive rate of return (MARR) of 18%. To solve this, future cash flows need to be estimated, taking into account the decrease in revenue and the increase in costs over time. Afterward, these cash flows can be fed into a financial model to compute the ERR, which is the discount rate that equates the sum of the present values of cash inflows and outflows to zero. However, without providing the actual mathematical computation and result, which requires either an iterative approach or financial software, we are just explaining the process to solve the ERR.