Question

1. Use the following information to answer the next four questions.

   Carson Co. is considering buying a tract of land for oil drilling. The company is certain they will find oil on the land, but they are unsure about the future demand for crude oil. Carson will spend a total of $15 million on initial costs if managers choose to pursue the project. Managers believe there is a 55% chance that demand for crude oil will be strong. If demand is strong, cash flows from the project are expected to be $6 million per year over the next 4 years. However a weak demand for crude will result in an annual cash flow of $4 million per year over 4 years.  Carson's required rate of return is 10%.

   Find the expected net present value of the project (in terms of millions). Round intermediate steps to four decimals.

   		1.1663
   		.5324
   		-9.9
   		16.1663
   		2.1854

6.25 points

Question 4

1. Now, assume Carson has the ability to reduce the scale of the project. Specifically, if the company desires, it can sell a portion of its drilling equipment for $3.5 million in year 2. If managers choose to contract, the company will only receive 70% of their previous expected future cash flows from operations in years 2-4. Find the value of the option to contract (in millions of dollars). Round intermediate steps to four decimals.

   		.0839
   		1.2472
   		.0809
   		.5634

6.25 points

Question 5

1. Now assume that Carson does not have the ability to contract, but they can abandon the project in year 2. If the company chooses to abandon, they will receive a total cash flow of $11 million in year 2. Find the net present value of the project with the abandonment option attached (in terms of millions of dollars). Round intermediate steps and your final answer to four decimals. Do not use the dollar sign when entering your answer.

6.25 points

Question 6

1. Now, suppose that Carson has the ability to either contract or abandon the project in year two as described in the previous two questions. Find the NPV of the project (in terms of millions of dollars) with both options attached.

Answer 1

Compute the expected cash flows, using the equation as shown below:

Expected cash flows = (Cash flows if demand is strong*Probability) + (Cash flows if demand is weak*Probability)

                                  = ($6,000,000*55%) + ($4,000,000*45%)

                                  = $5,100,000

Hence, the expected annual cash flows will be $5,100,000.

Compute the net present value (NPV) of the project, using the equation as shown below:

NPV = (Annual cash flows*PVIFA_{10%, 4 years}) – Initial investment

         = ($5,100,000*3.1699) - $15,000,000

         = $1,166,490 or 1.16649 million

Hence, the NPV is $1.16649 million.