The tribal government of the Fort Peck Indian Reservation is considering whether to allow development of a small but valuable shale oil deposit.

The tribal government of the Fort Peck Indian Reservation is considering whether to allow development of a small but valuable shale oil deposit. Not having the resources to develop and mine the deposit themselves, the tribe has the option to sell a lease to a mining company for an immediate one-time fee of $13 million—resources that can be used to address many development challenges on the reservation. The lease will expire (and the deposit will likely be mined out) in 25 years. A panel of experts suggests that the the use of hydraulic fracturing (fracking) to extract the oil, despite the use of best practices to avoid contamination, will likely result in contamination of surface and groundwater supplies in a manner that will increase health risks for some residents. Best estimates of these health-related damages (willingness to pay to avoid the damage) are a total of $30 million. Moreover, the health effects are not likely to be experienced until the end of the 25 year lease.

(a) Suppose that the tribe chooses a discount rate of .06. What is the present value of the damages created by the project? What is the net present value of the project from the vantage of the tribal government? Assuming this is the best (i.e. most efficient) way to develop the shale resource, is doing so justifiable on the basis of economic efficiency?

(b) Find the breakeven discount rate such that the net present value of this development opportunity is zero (i.e. find the internal rate of return).

(c) The tribal government has decided to allow the project to go forward. However, as a measure to deal with perceived inequities across generations, they decide to invest a substantial portion of the lease payment. Assume that $12 million is invested at a 5% annual rate (compounded annually). Will the future value of this investment be sufficient to compensate those that suffer damages in year 25? 

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