Question

Deep Sea Drilling is evaluating drilling for oil in the Gulf of Mexico. It will cost $830 million to buy an oil rig. Drilling would start immediately. The company has a cost of capital of 9%.

There is a 50% probability that the new well will be successful, in which case the free cash flow from the well will be $200 million per year for 20 years. Otherwise, it will only generate $40 million per year for 10 years.

Part 1: What is the NPV of the project (in $ million)?

Part 2: In fact, the company can abandon the project after the first year and sell the oil rig for $664 million. What is the NPV of the project now (in $ million)?

Part 3: What is the value of the option (in $ million)?

Answer 1

Part 1: NPV of project

NPV = Present value of cash inflow (PVCI) - Present value of cash outflow(PVCO)

PVCO = $ 830 millions

PVCI = Sum of [ Probablity * NPV ]

         = 50% * [ 200 million * PVAF( rate of interest, number of years) ] + 50% * [ 40 million * PVAF( rate of interest, number of years ) ]

         = 50% * [ 200 million * PVAF(9%, 20) ] + 50% * [ 40 million * PVAF(9%, 10) ]

         = 50% * [ 200 million * 9.12855 ] + 50% * [ 40 million * 6.41766 ]

         = 50% * 1825.71 + 50% * 256.7064

         = $ 1041.2082 Million

NPV = 1041.2082 - 830

        = $ 211.21 Millions

Part 2 : Abandon the project

Company will abandon the project if it is unsuccessful.

Thus, company will earn $ 40 million

PVCI = [ $ 664 million + 40 million ] * PVIF( rate of interest, number of years)

       = [ $ 664 million + 40 million ] * PVIF( 9%, 1 )

       = $ 704 million * 1/1.09

       = 645.87 million

NPV = 645.87 - 830

        = - $ 184.13 millions

Part 3: Value of option

Value of option = NPV in Part 1 - NPV in part 2

                     = 211.21 - ( - 184.13)

                    = $ 395.34 Millions Answer