Question

Investment Timing Option: Decision-Tree Analysis The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $14 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $6.72 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $16 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $7.56 million a year for 4 years and a 10% chance that they would be $3.64 million a year for 4 years. Assume all cash flows are discounted at 11%. If the company chooses to drill today, what is the project's net present value? Negative value, if any, should be indicated by a minus sign. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places. $ million Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?

Answer 1

If they wait for 2 more year, then expected payoff= 7.56*90%+10%*3.64=$7.168 mn

NPV analysis if they start drilling today,

Year	Cash Flow (in $ mn)	Discounted Cash Flow ($ mn) (Cash Flow/1.11^year)
0	(14.00)	(14.00)
1	6.72	6.05
2	6.72	5.45
3	6.72	4.91
4	6.72	4.43
	NPV (Total of discounted cash flow)	6.85

And, NPV analysis if they start drilling 2 year after:

Year	Cash Flow (in $ mn)	Discounted Cash Flow ($ mn) (Cash Flow/1.11^year)
2	(16.00)	(12.99)
3	7.17	5.24
4	7.17	4.72
5	7.17	4.25
6	7.17	3.83
	NPV (Total of discounted cash flow)	5.06

So, As the NPV of drilling is more than if they start drilling 2 year after. So, they should start drilling now only instead of waiting for 2 more years.