You own three oil wells in Vidalia, Texas. They are expected to produce 7,000 barrels next year in total, but production is declining by 6 percent every year after that. Fortunately, you have a contract fixing the selling price at $15 per barrel for the next 12 years. What is the present value of the revenues from the well during the remaining life of the contract? Assume a discount rate of 8 percent.

• 608,254
• 647,079
• 672,890
• 1,126,919
• 1,138,907

References

Lo, Andrew W.; Wang, Jiang. "MIT Sloan Finance Problems and Solutions Collection Finance Theory I" (PDF). alo.mit.edu. Retrieved November 30, 2023.

Solution: A

Assume all the oil is sold at the end of each year; for example the PV of the production for the first year is

$7000×$15/1.08 = $97, 222.

The PV of the second year production is

$6580×$15/1.08² = $84, 619.

The PV of the total production in the first 12 years is $608,254 and by then the annual production has declined to 3,544 barrels.

References

Lo, Andrew W.; Wang, Jiang. "MIT Sloan Finance Problems and Solutions Collection Finance Theory I" (PDF). alo.mit.edu. Retrieved November 30, 2023.