Question

The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $6 million today. Bush estimates that once drilled, the oil will generate positive cash flows of $3.9 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project will cost $9 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 85% chance that the cash flows will be $4.2 million a year for 4 years, and there is a 15% chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%.

a. If the company chooses to drill today, what is the project’s expected net present value?

b. Would it make sense to wait 2 years before deciding whether to drill?

(Yes,No), because the NPV of waiting two years is $_______ and (less,greater) than going ahead and proceeding with the project today.

c. What is the value of the investment timing option?

d. What disadvantages might arise from delaying a project such as this drilling project?

Answer 1

a) Projects NPV = annual cash inflow * PVIFA(disc rate, n) - initial cash outflow
3.9m * PVIFA(10%,4) - 6m = 3.9*3.17 - 6 = 6.363m
b) Projects NPV if project starts after 2 years:
(4.2*0.85 + 2.2*0.15) * PVIFA(10%,4) - 9m = 3.9*3.17 - 9 = 3.363m
No, because the NPV of waiting two years is $ 3.363m and less than going ahead and proceeding with the project today.
c) The value of investment timing option is 6.363 - 3.363 = 3m
d) The disadvantages that might arise from delaying a project:
1) Inflation effect will raise the investment cost.
2) The annual cash flow got affect by the market rate, which could reduce giving lower present value of cash flow.
3) The resources, not having alternative use, could degrade by time on project delay.
4) The labor remains idle.
5) The labor and materials rates could rise of present, so rise in expenses.