CP Inc. owns an undeveloped oilfield. In order to begin extraction of oil immedi

Question

CP Inc. owns an undeveloped oilfield. In order to begin extraction of oil immediately, an investment of $48 million would be needed. One year from now, an investment of $50 million would be needed to begin extraction of oil. Extraction costs would be $25/barrel in any year. The quantity of oil is expected to be 400,000 barrels per year indefinitely. The risk-free rate is 10% per year and that is also the cost of capital (ignore any taxes). The price of oil is $42/barrel, but a year from now it will change to $65/barrel or $30/barrel with equal probability. The price will then remain at the new level indefinitely.

(a) Suppose CP must invest now or not at all. What is the expected NPV of the opportunity?

(b) Suppose CP can invest now, in a year, or not at all. What is the expected NPV of the opportunity?

(c) For the scenario of part (b), calculate the value of the (real) option to delay investment.

Explanation / Answer

(a)

Working:

Sales 400000 x 47.5 19000000 Variable cost 400000 x 25 10000000 Contribution margin 9000000 9 Million required return 10% Present value C/r 90 Present value of cost: = (48*1)+(50*.909) = 93.45 Expected Net present value = $    (3.45)

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