Question

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 $12 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $5.52 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 $15 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $6.6 million a year for 4 years and a 10% chance that they would be $3.24 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? A negative value should be entered with a negative sign. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.

Answer 1

The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns.

The Net Present Value is $5.12m if the company chooses to drill for oil today.

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 $15 million.

The Net Present Value is $3.60m if the company chooses to drill for oil after waiting for 2 years.