Question

Problem 26-02
Investment Timing Option: Decision-Tree Analysis

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 $12 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $5.76 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 $15 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $6.6 million a year for 4 years and a 10% chance that they would be $3.12 million a year for 4 years. Assume all cash flows are discounted at 12%.

1. If the company chooses to drill today, what is the project's net present value? A negative value should be entered with a negative sign. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. 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.

Answer 1

a. NPV (if choose to drill today) = $5.5 million

b. NPV (Year 0) if waited 2 years = $3.18 million versus $5.50 million if drilled today. Since the NPV if driller today is higher:

No. it makes sense to drill today.