IBB-Heritage Oil Company has just received the exploration rights to an oil fiel
ID: 2477916 • Letter: I
Question
IBB-Heritage Oil Company has just received the exploration rights to an oil field with substantial reserves. The estimated reserves amount to 10 million barrels, and the estimated present value of the development cost is $12 per barrel. The current price of oil is $20 per barrel, and the estimated production cost per barrel is $6. The company also proposes to extract 4% of its reserves each year to meet its cash flow needs. The company has the rights to these reserves for the next 20 years and the twenty-year T-bond rate is 7%. The annualized variance in the price of oil is estimated to be 4%. Estimate the value of this oil company. Assume this is the only project for the company.
Explanation / Answer
Reserves 10 Present value factor 20 years at 7% 0.2584 Present value of reserves 2.584 Increase in retained earnings Sales 20 cost -6 Development cost -12 Net cash inflow 2 Present value 0.5168 Less present value of 4% every year 0.10336 Net increase in retained earning 0.41344 total value of the oil company present value 2.99744