Question

In: Finance

Deep Sea Drilling is evaluating drilling for oil in the Gulf of Mexico. It will cost...

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)?

Solutions

Expert Solution

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


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