Question

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.55 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.275 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.84 million. Moreover, if it waits two years, there is a 50% chance that the cash flows would be $2.354 million a year for four years, and there is a 50% chance that the cash flows will be $1.309 million a year for four years. Assume that all cash flows are discounted at a 7% WACC.

a. If the company chooses to drill today, what is the project’s net present value? Round your answer to five decimal places.
$ million

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.26 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.13 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.93 million. Moreover, if it waits two years, there is a 75% chance that the cash flows would be $2.297 million a year for four years, and there is a 25% chance that the cash flows will be $1.123 million a year for four years. Assume that all cash flows are discounted at a 12% WACC.

b. What is the project’s net present value in today’s dollars, if the firm waits two years before deciding whether to drill?
$ million (to 5 decimals)

Answer 1

Answer - a

If Florida Seaside Oil Exploration Company chooses to drill today, the NPV shall be calculated using the discount rate of 7%

Statement showing Net Present Value of the project

Amount (in million $)

Year	Particulars	Amount (A)	Discount Factor @ 7% (B)	Present Value     (A * B)
0	Project cost	-4.55	1	-4.55
1 to 4	Cash flow	2.275	3.3872	7.70588
	Net Present Value	3.15588

Answer - b

If Florida Seaside Oil Exploration Company waits two years before deciding whether to drill, the NPV shall be calculated using the discount rate of 12%

Statement showing expected cash flow

Amount (in million $)

Particulars	Amount (A)	Probability (B)	Estimated Cash Flow          (A * B)
Cash Flow	2.297	75%	1.72275
Cash Flow	1.123	25%	0.28075
TOTAL	2.00350

Statement showing Net Present Value of the project

Amount (in million $)

Year	Particulars	Amount (A)	Discount Factor @ 12% (B)	Present Value     (A * B)
2	Project cost	-4.93	0.7972	-3.93020
3 to 6	Cash flow	2.00350	2.4214	4.85119
	Net Present Value	0.92099