The Bush Oil Company is deciding whether to drill for oil on a tract of land tha
ID: 2650261 • Letter: T
Question
The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project would cost $8 million today. Bush estimates that once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 4 years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it would have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project would cost $9 million. Moreover, if it waits 2 years, there is a 90% chance that the net cash flows would be $4.2 million a year for 4 years, and there is a 10% chance that the cash flows would be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%.
a. if the company chooses to drill today, what is the project's expected net present value?
b. would it make sense to wait 2 years befopre decising whether to drill? explain
C. what is the value of the investment timing option?
d. what disadvantages might arise from delaying a project such as this drilling project?
Explanation / Answer
1.
If the company drills today
Year
0
1
2
3
4
Initial cash outlay
-8
cash inflow
4
4
4
4
Net cash flow
-8
4
4
4
4
P.v@10%
-8
3.636363636
3.30578512
3.0052592
2.732053821
NPV
4.679461785
Net Present value=$ 4.68 million.
2.
If company waits for 2 year
Expected cash flow=0.9*4.2+0.1*2.2=$4 million
Year
0
1
2
3
4
Initial cash outlay
-9
cash inflow
4.00
4.00
4.00
4.00
Net cash fow
-9
4
4
4
4
P.v@10%
-9
3.636363636
3.30578512
3.0052592
2.732053821
NPV
3.679461785
NPV=$3.68 million
NPV is less than if the company drills today, thus it makes no sense to wait for two years
Year
0
1
2
3
4
Initial cash outlay
-8
cash inflow
4
4
4
4
Net cash flow
-8
4
4
4
4
P.v@10%
-8
3.636363636
3.30578512
3.0052592
2.732053821
NPV
4.679461785
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