Question

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.57 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.285 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $5.09 million. Moreover, if it waits two years, there is a 65% chance that the cash flows would be $2.434 million a year for four years, and there is a 35% chance that the cash flows will be $1.1 million a year for four years. Assume that all cash flows are discounted at a 9% WACC.

If the company chooses to drill today, what is the project’s net present value? Round your answer to five decimal places.

Quantitative Problem 2:

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.92 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.46 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $5.21 million. Moreover, if it waits two years, there is a 75% chance that the cash flows would be $2.643 million a year for four years, and there is a 25% chance that the cash flows will be $1.495 million a year for four years. Assume that all cash flows are discounted at a 10% WACC.

What is the project’s net present value in today’s dollars, if the firm waits two years before deciding whether to drill?
$ million (to 5 decimals)

Quantitative Problem 3:

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.14 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.07 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.47 million. Moreover, if it waits two years, there is a 60% chance that the cash flows would be $2.125 million a year for four years, and there is a 40% chance that the cash flows will be $0.691 million a year for four years. Assume that all cash flows are discounted at a 13% WACC.

Will the company delay the project and wait until they have more information?
-Select-YesNo

Answer 1

1) Statement showing NPV

Particulars	0	1	2	3	4	NPV = total of PV
Cost of project	-4570000
Cash flow		2285000	2285000	2285000	2285000
Total cash flow	-4570000	2285000	2285000	2285000	2285000
PVIF @ 9%	1.0000	0.9174	0.8417	0.7722	0.7084
PV	-4570000	2096330.28	1923238.78	1764439.25	1618751.61	2832759.92

Thus NPV = $ 2832759.92

Thus Ans $ 2.83276 million

2) Let us firt find expected cash flow

Expected cash flow = $2.643 million x 75% + $1.495 million x 25%

= 1.98225 million + 0.37375 million

= $ 2.356 million

Particulars (Rs in mln)	0	1	2	3	4	NPV = total of PV
Cost of project	-5.21
Cash flow		2.35600	2.35600	2.35600	2.35600
Total cash flow	-5.21	2.35600	2.35600	2.35600	2.35600
PVIF @ 10%	1.0000	0.9091	0.8264	0.7513	0.6830
PV	-5.21000	2.14182	1.94711	1.77010	1.60918	2.25820

Thus NPV at end of year 2 = $ 2.25820 million

project’s net present value in today’s dollars =NPV at end of year 2 /(1+r)^n

= 2.25820/(1+10%)^2

= 2.25820 / 1.21

= $1.86628 million

3)  Statement showing NPV if company does'nt wait for 2 years

Particulars (Rs in mln)	0	1	2	3	4	NPV = total of PV
Cost of project	-4.14
Cash flow		2.07000	2.07000	2.07000	2.07000
Total cash flow	-4.14	2.07000	2.07000	2.07000	2.07000
PVIF @ 13%	1.0000	0.8850	0.7831	0.6931	0.6133
PV	-4.14000	1.83186	1.62111	1.43461	1.26957	2.01716

Thus NPV if company does'nt wait for 2 years = $ 2.01716 million

Now lets calculate Expected cash flow if company waits for two year

Expected cash flow = $2.125 million x 60% + $0.691 million x 40%

= $ 1.55140 million

Statement showing NPV at end of year 2

Particulars (Rs in mln)	0	1	2	3	4	NPV = total of PV
Cost of project	-4.47
Cash flow		1.55140	1.55140	1.55140	1.55140
Total cash flow	-4.47	1.55140	1.55140	1.55140	1.55140
PVIF @ 13%	1.0000	0.8850	0.7831	0.6931	0.6133
PV	-4.47000	1.37292	1.21497	1.07520	0.95150	0.14459

Thus NPV at end of year 2 = $ 0.14459 million

project’s net present value in today’s dollars =NPV at end of year 2 /(1+r)^n

= 0.14459/(1+13%)^2

= 0.14459 / 1.2769

= $0.11324 million

Thus Company should not wait for 2 years

Ans) NO