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 8%.

There is a 50% probability that the new well will be succcessful, 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 milion 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 the project is calculated as below

Cash Outflow at Year 0 is $830 Million

Cash Inflow Anticipated for year 1 - 10 is = $200 *50% + $40*50%=$120 Million

Cash Inflow Anticipated for year 11 - 20 is = $200 *50% + $0*50%=$100 Million

Year	Cash Flow	PVf(8%)	PV
0	($830)	1.00	($830.00)
1	$120	0.93	$111.11
2	$120	0.86	$102.88
3	$120	0.79	$95.26
4	$120	0.74	$88.20
5	$120	0.68	$81.67
6	$120	0.63	$75.62
7	$120	0.58	$70.02
8	$120	0.54	$64.83
9	$120	0.50	$60.03
10	$120	0.46	$55.58
11	$100	0.43	$42.89
12	$100	0.40	$39.71
13	$100	0.37	$36.77
14	$100	0.34	$34.05
15	$100	0.32	$31.52
16	$100	0.29	$29.19
17	$100	0.27	$27.03
18	$100	0.25	$25.02
19	$100	0.23	$23.17
20	$100	0.21	$21.45
	NPV		$286.02

Part 2 NPV of the project if the company sells the oil rig after Year 1

Year	Cash Flow	PVf(8%)	PV
0	($830)	1.00	($830.00)
1	$120	0.93	$111.11
1	$664	0.93	$614.81
	NPV		($104.07)

Since NPV is negative the propsal should not be accepted