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 $6 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 $13 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $6.3 million a year for 4 years and a 10% chance that they would be $3.3 million a year for 4 years. Assume all cash flows are discounted at 9%. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. 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?

Answer 1

There are two options with the company:

a) To drill today where cost = $12 million , cash flows= $6million , n= 4 years , discount rate = 9%

b) To wait for 2 years where cost= $13 million , discount rate = 9% , n = 4years but Net cash flows are:

• $6.3 million with 90% probability
• $3.3 million with 10% probability

We will calculate NPV for both scenarios, compare them and then take a decision.

NPV = Present value of cash inflows - PV of cash outflows

PV of cash inflows = CF /(1+r)^n

Then we will use the decision tree analysis to find the NPV of both the probabilities of second case.

After finding the NPV of both probabilities, we will find the Expected probability

Expected probability = (10% * NPV of 10%) + (90% * NPV of 90%)

So NPV of case 2 is less than Case 1 , so we will not delay for 2 years and start the drill immediately.