Question

Jerry discovers petroleum bubbling up from the ground near his barn. He pays $8,000 for a petroleum engineer to take a look. The engineer says that, if Jerry puts up a $2 million oil rig, he can expect to pump 40,000 barrels of oil from the ground each year for eight years, and then the well will run dry. Jerry figures he can sell the oil for $35 per barrel at the wellhead (that is, the buyer will pay all transportation). Jerry has a discount rate of 22%. Should he invest in the oil rig

Answer 1

To determine whether Jerry should invest in the oil rig, we need to calculate the net present value (NPV) of the investment. NPV takes into account the future cash flows from the oil rig and discounts them to their present value using the discount rate. The NPV of the investment is $175,231.22, which is positive. This means that the investment is profitable and Jerry should invest in the oil rig.

Step-by-step explanation:

To determine whether Jerry should invest in the oil rig, we need to calculate the net present value (NPV) of the investment. NPV takes into account the future cash flows from the oil rig and discounts them to their present value using the discount rate.

First, we need to calculate the annual profit from the oil rig. Jerry can expect to pump 40,000 barrels of oil per year for 8 years, so the total barrels of oil pumped will be 40,000 x 8 = 320,000 barrels.
Then, we calculate the total revenue generated from selling the oil, which is 320,000 x $35 = $11,200,000.
We subtract the initial investment of $2,000,000 and the engineer's fee of $8,000 to get the total cost of the investment: $2,000,000 + $8,000 = $2,008,000.
Next, we calculate the net profit by subtracting the total cost from the total revenue: $11,200,000 - $2,008,000 = $9,192,000.
Now, we calculate the present value of the net profit. We divide the net profit by the discount rate plus 1 raised to the power of the number of years: $9,192,000 / (1 + 0.22)^8 = $2,175,231.22.
Finally, we subtract the initial investment to find the NPV: $2,175,231.22 - $2,000,000 = $175,231.22.

The NPV of the investment is $175,231.22, which is positive. This means that the investment is profitable and Jerry should invest in the oil rig.

Answer 2

He should invest in oil rig as it gives profit of $9,632,000.

Step-by-step explanation:

According to the scenario, computation of the given data are as follows:

Paid to engineer = $8,000

Invest in oil rig = $2,000,000

Rate of discount = 22%

So, Discount amount = $2,000,000 X 22% = = $440,000

Expected oil = 40,000 barrels per year

So, Total oil after 8 years = 40,000 × 8 = 320,000 barrels

Selling price = $35

So, total sales value = 320,000 × $35 = $11,200,000

Total profit = (Total sales + Discount amount) - (Total Investment + Paid to engineer)

= ( $11,200,000 + $440,000 ) - ( $2,000,000 + $8,000)

= $11,640,000 - $2,008,000

= $9,632,000

As this gives the profit of $9,632,000, so he should invest in oil rig.