An associate of yours is offering your firm to buy an oil well that will produce 1,000,000barrels of oil next year. Assume for simplicity that the oil is available at the end of theyear. The well will be closed forever after that. Suppose that the operating expenses are$10,000,000. Suppose that the forward price for oil delivered one year from today is $12barrel and that the risk-free interest rate is 15%.

a. What is the maximum amount that you are willing to pay for the oil well?

Maximum Amount that we are willing to pay for Oil Well

Present Value of Cash Inflows = 1,000,000 barrels x $ 12 x (1 / 1.15) = $ 10,434,782.60

Present Value of Cash Outflows = $ 10,000,000 x (1 / 1.15) = $ 8,695,652.17

Net Present Value = $ 1,739,130.43

i.e. Maximum amount that we are willing to pay for Oil Well is $ 1,739,130.43

b. Form a perfect tracking portfolio for the oil well. Prove that if the actual oil pricegoes to $20 one year from today, the tracking portfolio that you built leaves youin the same cash-flow position as if you bought the oil well. (Show calculations)