Question

The Engler 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 $8 million today. Engler estimates that once drilled, the oil will generate positive cash flows of $4.5 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. Engler estimates that if it waits 2 years, the project will cost $11 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that the cash flows will be $4.6 million a year for 4 years, and there is a 5% chance that the cash flows will be $2.6 million a year for 4 years. Assume that all cash flows are discounted at 11%.

1. If the company chooses to drill today, what is the project’s expected net present value? Enter your answer in millions. For example, an answer of $1.2345 million should be entered as 1.2345, not 1,234,500. Do not round intermediate calculations. Round your answer to four decimal places.
   $    million
2. Would it make sense to wait 2 years before deciding whether to drill? Enter your answer in millions. For example, an answer of $1.2345 million should be entered as 1.2345, not 1,234,500. Do not round intermediate calculations. Round your answer to four decimal places.
   NPV of waiting: $    million
   -Select-YesNoItem 3 , because the NPV of waiting two years is -Select-lessgreaterItem 4 than going ahead and proceeding with the project today.
3. What is the value of the investment timing option? Enter your answer in millions. For example, an answer of $1.2345 million should be entered as 1.2345, not 1,234,500. If an amount is zero, enter 0. Do not round intermediate calculations. Round your answer to four decimal places.
   $   million

Answer 1

Answer: Initial Investment: $8 million

Cash flow: $4.5 million

Life of project: 4 years

Discount rate: 11% (1+0.11)=1.11

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

NPV = R ×	1 − (1 + i)-n	− Initial Investment
	i

In the above formula,
R is the net cash inflow expected to be received in each period;
i is the required rate of return per period (i.e. the hurdle rate, discount rate);
n are the number of periods during which the project is expected to operate and generate cash inflows.

Net Present Value
= $4.5million × (1 − (1 + 11%)^-4) ÷ 11% − $8million
= $4.5 million × (1 − 1.11^-4) ÷ 0.11 − $8 million
≈ $4.5 million × (1 − 0.6587309741) ÷ 0.11 − $8 million
≈ $4.5 million × 0.3412690259÷ 0.11 − $8 million
≈ $4.5 million × 3.10244569 − $8 million
≈ $13.961005605 million − $8 million
≈ $5.9610 million

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

WAIT TWO YEARS:

Low 5% prob				High 95% prob
Year	NPV			Year	NPV
0	0	-		0	0	-
1	0	-		1	0	-
2	‘-11 million			2	‘-11 million
3	‘2.6/(1.11)^1	2.3423		3	4.6/(1.11)^1	4.1441
4	2.6/(1.11)^2	2.1102		4	4.6/(1.11)^2	3.7334
5	2.6/(1.11)^3	1.9011		5	4.6/(1.11)^3	3.3635
6	2.6/(1.11)^4	1.7127		6	4.6/(1.11)^4	3.0303
Total		4.6409		Total		14.2713

Low CF Scenario: NPV= (-11+4.6409)/(1.11)^2=$-5.1611 million

High CF Scenario: NPV= (-11+14.2713)/(1.11)*2= $ 2.6550 million

Expected NPV= 0.05(-5.1611)+ 0.95(26550)=$25222.7580 million

if the cash flows are only 2.6 million, the NPV of the project is negative and thus would not be undertaken. The value of the option of waiting two years is evaluated as 0.05($0)+0.95(26550)=$25222.5million

Since the NPV of waiting two years is less than going ahead and proceeding with the project today it makes sense to drill today.