The Karns Company is deciding whether to drill for oil on a tract of land the co

Question

The Karns Company is deciding whether to drill for oil on a tract of land the company owns. The company estimates the project would cost $8 million today. Karns 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. Although the company is fairly confident about the 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 $9 million. Moreover, it it waits 2 years, then there is a 90% chance that the net cash flows would be $4.2 million a year for 4 years and a 10% chance that they would be $2.2 million a year for 4 years. Assume all cash flows are discounted at 10%.

a. If the company chooses to drill today, what is the project’s net present value?

b. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?

Explanation / Answer

a. If the company chooses to drill today

Initial Investment = $8,000,000

Annual cash flows for years = $4,000,000

Present value of annual cash flows = $4,000,000/1.10 + $4,000,000/1.102 $4,000,000/1.103 + $4,000,000/1.104

= $3,636,363.64 + $3,305,785.12 + $3,005,259.20 + $2,732,053.82 = $12,679,461.79

NPV = Present value of Annual cash flows – Initial Investment = $12,679,461.79 - $8,000,000 = $4,679,461.79 = $4.68 million

b. Wait 2 years before deciding whether to drill

If the net cash flows is $4.2 million per annum

Present value of annual cash flows at year 2 = $4,200,000/1.10 + $4,200,000/1.102 $4,200,000/1.103 + $4,200,000/1.104

= $3,818,181.82 + $3,471,074.38 + $3,155,522.16 + 2,868,656.51 =$13,313,484.87

NPV at year 2=$13,313,484.87 - $9,000,000 = $4,313,484.87 = $4.313 million

NPV at year 0 = $4.313 million / 1.102 = $3.564 million

If the net cash flows is $2.2 million per annum

Present value of annual cash flows at year 2= $2,200,000/1.10 + $2,200,000/1.102 $2,200,000/1.103 + $2,200,000/1.104

= $2,000,000 + $1,818,181.22 + $1,652,892.56 + $1,502,629.60 = $6,973,703.98

NPV at year 2=$6,973,703.98 - $9,000,000 = -$2,026,296.02 = -$2.026 million

NPV at year 0 = $2.026 million / 1.102 = $1.674 million

Probability of $4.2 million cash flow is 90% whileprobability of $2.2 million cash flow is 10%.

Since NPV for $2.2 million cash flow is negative, it will not be considered and its NPV will be taken as zero

Expected NPV at Year 0 = ($3.564 million * 0.90) + ($0 million * 0.10) = $3.21 million

NPV of waiting for 2 years is less than the NPV of drilling it today. Hence, it does not make sense for waiting to drill for 2 years.

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