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

Answer:

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

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.