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 $4.45 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.225 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 $5.16 million. Moreover, if it waits two years, there is a 70% chance that the cash flows would be $2.284 million a year for four years, and there is a 30% chance that the cash flows will be $1.621 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.
$ million

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 $4.99 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.495 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 $5.71 million. Moreover, if it waits two years, there is a 65% chance that the cash flows would be $2.563 million a year for four years, and there is a 35% chance that the cash flows will be $1.768 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 $4.82 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.41 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 $5.22 million. Moreover, if it waits two years, there is a 60% chance that the cash flows would be $2.535 million a year for four years, and there is a 40% chance that the cash flows will be $1.496 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?

Answer 1

Problem 1

If the company chooses to drill today, the project’s net present value is being calculated below

NPV = Present value of inflow - Present value of outflow

Year	Particular	Amount ($)	Discounting @ 9%	Amount
0	Outflow	4.45	1	(4.45)
1	Inflow	2.225	.9174	2.041215
2	Inflow	2.225	.8417	1.8727825
3	Inflow	2.225	.7722	1.718145
4	Inflow	2.225	.7084	1.57619

Discounting factor @ 9 % = 1 /1.09 = .9174 year 1

year 2 = 1/1.09^2 = .8417

year 3 = 1/ 1.09^3 = .7722

year 4 = 1 /1.09^4 = .7084

NPV = Present value of inflow - Present value of outflow

Pv inflow total = 2.041215+1.8727825+1.718145+1.57619 = 7.2083325

Pv of outflow = 4.45

By substracting we get i.e. Net present value = 7.2083325 - 4.45 = 2.75833

Problem 2

Year	Particular	Amount ($)	Discounting @ 10 %	Amount
0	Outflow	5.71	1	(5.71)
1	Inflow	2.563	.9090	2.329767
2	Inflow	2.563	.8264	2.1180632
3	Inflow	2.563	.7513	1.9255819
4	Inflow	2.563	.6830	1.750529

Pv of Inflow = 2.329767+2.1180632+1.9255819+1.750529 = 8.1239411

Pv of outfow = 5.71

By substracting we get i.e. Net present value = 8.1239411 - 5.71 = 2.4139321

Problem 3 case A

Year	Particular	Amount ($)	Discounting @ 13 %	Amount
0	Outflow	4.82	1	(4.82)
1	Inflow	2.41	.8850	2.13285
2	Inflow	2.41	.7831	1.887271
3	Inflow	2.41	.6930	1.67013
4	Inflow	2.41	.6133	1.478053

Pv of Inflow = 2.13285+1.887271+1.67013+1.478053 = 7.168304

Pv of outfow = 4.82

By substracting we get i.e. Net present value = 2.348304

Case B

Year	Particular	Amount ($)	Discounting @ 13 %	Amount
0	Outflow	5.22	1	(5.22)
1	Inflow	2.535	.8850	2.243475
2	Inflow	2.535	.7831	1.9851585
3	Inflow	2.535	.6930	1.756755
4	Inflow	2.535	.6133	1.5547155

Pv of Inflow = 2.243475+1.9851585+1.756755+1.5547155 = 7.540104

Pv of outflow = 5.22

By subtracting we get i.e. Net present value = 7.540104 - 5.22 = 2.320104

Will the company delay the project and wait until they have more information

No, the company should not delay the project and wait for more information because in starting the project now will give more net present value than starting the project later.