Question

Ewing Oil Company (EOC) is examining a new oil field. If EOC drills today, it will cost $9 million and the oil field is expected to create cash flows of $3.5 million per year for the next 5 years. Alternatively, the company could spend $350,000 today for a geological survey. The survey would take two years and result in a better estimate of the oil field’s resources. There is an 80 percent chance that the survey would find the oil field would produce cash flows of $4.5 million per year for 6 years and a 20 percent chance that the cash flows would be $2.5 million for 5 years. In 2 years, it would cost $11 million to drill the necessary wells. The required return is 14 percent. Should EOC drill now or conduct the geological survey?

*Please include excel formulas with answer*

Answer 1

The best method to evaluate which method will result in higher cash inflows is using Net Present Value.

Net Present Value (NPV) is a tool of arriving at Present value of a project by finding the difference between the present value of cash inflows and present value of cash outflows. It takes into consideration the time value of money and is near to realistic as it uses the cost of capital or expected return rate as a discounting factor.

In the given problem, there are 2 options. One is to drill the oil well now and expect cash flows of $3.5 million per year for 5 years. Another option is to conduct a geological survey by spending $350,000 and then based on the survey results dig a oil well after 2 years, which as either a chance of 80% of earning $4.5 million p.a. for 6 years or a chance of 20% of earning $2.5 million for 5 years.

Since the life of both the projects are different, we will have to also use Equivalent Annual Annuity so as to compare both the projects on equal grounds.

Option 1:

Option 2:

In this option the a geological survey will be conducted now, that is Year 0, and then after 2 years, i.e. in year 2, a well will be dug, and cash flows will be expected from year 3 for next 6 years, i.e upto year 8.

Since, there is a probability of cash flows that might occur, we will first find expected cash flows and then NPV and EAA will be calculated using such expected cash flows.

While comparing the two options, though NPV is higher in case of option 2, Equivalent Annual Annuity is higher for Option 1. Hence it is advisable for EOC to drill now.