Question

The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $10 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $4.6 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $12.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $5.2 million a year for 4 years and a 10% chance that they would be $2.8 million a year for 4 years. Assume all cash flows are discounted at 11%.

1. If the company chooses to drill today, what is the project's net present value? Negative value, if any, should be indicated by a minus sign. 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 two decimal places.
   $     million
   
2. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?
   -Select-Yes, it makes sense to wait two years to drill.No, it makes sense to drill today.Item 2

Answer 1

All financials below are in $ mn

Part (a)

Initial investment, C₀ = 10

Annual cash flows, C = 4.6 over N = 4 years, Discount rate = R = 11%

Hence, PV of annual cash flows = PV of annuity = C / R x [1 - (1 + R)^-N] = 4.6 / 11% x [1 - (1 + 11%)^-4] = 14.27

Hence, NPV = -C₀ + PV of annual cash flows = -10 +14.27 = 4.27

Hence,your answer should be: $ 4.27 million

Part (b)

Please see the decision tree below:

On 90% node, PV of annual cash flows = C / R x [1 - (1 + R)^-N] = 5.2 / 11% x [1 - (1 + 11%)^-4] = 16.13

On 10% node, PV of annual cash flows = C / R x [1 - (1 + R)^-N] = 2.8 / 11% x [1 - (1 + 11%)^-4] = 8.69

Hence, expected PV of annual cash flows = 0.9 x 16.13 + 0.10 x 8.69 = 15.39

Hence, NPV = -C₀ + 15.39 = -12.5 + 15.39 = 2.89

Since NPV of part (a) > NPV of part (b), it makes sense to drill today. Hence, your answer should be:

No, it makes sense to drill today