The Bush Oil Company is deciding whether to drill for oil on a tract of land tha

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%.

1. If the company chooses to drill today, what is the project's net present value? Round your answer to four decimal places.

$ million

2. What is the value of the investment timing option? If necessary round your answer to four decimal places.

$ million

Explanation / Answer

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