Question

Orange Oil Exploration Company is deciding whether to drill for oil off the coast of Florida. The company estimates that the project would cost $4.12 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.06 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. Orange Oil Company estimates that if it waits two years, the project would cost $4.84 million. Moreover, if it waits two years, there is a 60% chance that the cash flows would be $2.186 million a year for four years, and there is a 40% chance that the cash flows will be $0.8 million a year for four years. Assume that all cash flows are discounted at a 11% WACC.

What is the project’s net present value in today’s dollars, if the firm waits two years before deciding whether to drill? Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to five decimal places.

Answer 1

If company decided to wait for two years then

Cash flow today or in year 0 = Cash flow in year 1 = 0

Cash flow in year 2 = - Cost after 2 years = - $4.84 million = - 4.84 x 1000000 = - $4840000

Cash flow with 60% probability for year 3 to 6 = 2.186million = $2186000

Cash flow with 40% probability for year 3 to 6 = 0.8 million = $800000

Expected cash flow for year 3 to 6 = 60% x Cash flow with 60% probability for year 3 to 6 + 40% x Cash flow with 40% probability for year 3 to 6 = 60% x 2186000 + 40% x 800000 = 1311600 + 320000 = 1631600

Year	2	3	4	5	6
Expected Cash Flow	-4840000	1631600	1631600	1631600	1631600

Present value at year 2 of expected cash flows of the project if firm decides to wait = -4840000 + 1631600 / (1+11%) + 1631600 / (1+11%)² + 1631600 / (1+11%)³ + 1631600 / (1+11%)⁴ = -4840000 + 1469909.9099 + 1324243.1620 + 1193011.8577 + 1074785.4574 = 221950.3870

NPV of the project in today's dollars if firm decided to wait = Present value at year 2 of expected cash flows of the project / (1+WACC)² = 221950.3870 / (1+11%)² = 221950.3870 / (1.11)² = 221950.3870 / 1.2321 = $180139.9132

NPV of the project in today's dollars if firm decides to wait = (180139.9132 / 1000000) millions = 0.1801399132 million = 0.18014 million (rounded to five decimal places)

Hence, NPV of the project in today's dollars if firm decides to wait = 0.18014 million