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2. Critique the validity of the Excel model provided. To do this:
a. Provide a list of the calculations you find to be in any way flawed or inadequate or misrepresentative.
1 The cost of capital is based on equity financing.
2 The tax rate is not given.
3 The depreciation has not been considered.
4 The probability has been applied wrongly.
b. For each of the items in the list you created for a) above, explain what is wrong and what needs to be done to correct the problem.
1 It has been assumed that all sources of financing has been done using the equity financing but as the company has low debt ratio therefore the company could have use the debt financing to decrease the cost of capital from 11.6% to 4.55%. Even if 50% from debt or 50% from equity would have been used, the cost of capital would be lower than 11.6%. But as the NPV is positive at higher rate therefore the NPV would be definitely more positive at lower rates.
2 The tax rate is not given, which should be considered as it will reduce the overall cash flow after tax of the oil well.
3 The depreciation has not been considered as no tax rate is given, therefore it would have no impact on the cash flow if no tax is assumed, but if a tax rate is applied it has to be calculated.
4 The probability should not be applied on the present value of net cash flow as if there will be dry well then there would be no cash flow, rather it should have been applied on initial investment present value which is equal to $5 million.
3. a. Calculate the NPV of the wildcat oil well, taking account of the probability of a dry hole, the shipping costs, the decline in production, and the forecasted increase in oil prices.
I have calculated NPV at 11.6% as it is giving the net present value, and I have also considered the tax rate of 35% which is normally to be paid by the company. Therefore the depreciation has been calculated on straight line basis for 15 years considering zero salvage value. The probability has been applied on the initial investment which will be a total loss for the company.
b. How long does production have to continue for the well to be a positive NPV investment? How did you figure out your answer, i.e., what approach did you take?
After 10.36 years or in the 11th year the NPV will be positive. The calculation has been in the excel sheet. The PV of last years has been deducted from NPV to arrive the year at which the NPV will be zero, after which the NPV will be positive.
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