Question

Investment Timing Option: Decision-Tree Analysis

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 $6 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $2.94 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 $8.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $3.18 million a year for 4 years and a 10% chance that they would be $1.56 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? Negative value, if any, should be indicated by a minus sign. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places. $ million

Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill? (Answers: Yes, it makes sense to wait two years to drill; No, it makes sense to drill today)

Answer 1

Solution

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