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 will cost $8 million today. Bush estimates that once drilled, the oil will generate positive cash flows of $4 million per year at the end of each of the next four years. Although the company is confident about its cash flow forecast, it recognizes that if it waits two years, it will have more information about the local geology as well as the price of oil. Bush estimates that if the company waits 2 years, the project will cost $9 million and cash flows will continue for 4 years after the initial investment. Moreover, if the company waits for 2 years, there is a .90 probability that cash flows will equal $4.2 million each year for four years, and a .10 probability that cash flows will equal $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%. a. If the company drills today, what is the project’s expected NPV? b. Would it make sense to wait 2 years before deciding whether to drill? Support your response with computations. c. What is the value of option to delay?

Explanation / Answer

a)

Initial investment = 8 million

cash flow each year = 4 million

life = 4 years

rate of discount = 10%

Now discount each year cash flows to get NPV

year 1:

4/(1.1) = 3.6363

year 2:

4/(1.1)^2 = 3.3057

year 3:

4/(1.1)^3 = 3.0052

year 4:

4/(1.1)^4 = 2.7321

Hence the total inflow = 3.636 + 3.3058 + 3.005 + 2.7321 = 12.6794( rough value)

total outflow = 8

Hence NPV = 12.6794-8 = 4.6794

b)

waited period i.e, 2 years

if this is the condition then the cost will be 9 million

10% low cash flow probablity i.e, 2.2 million for the next 4 years

90% higher cash flow probablity i.e, 4.2 million for the next 4 years

rate of discount is 10% as usual

life = 4 years

here 2 years no cash flow as it is the waiting period

the cash flow starts at 3rd year.

investment done at the end of year 2

let us take 10% probablity condition with cash flow 2.2 per year

year 0

= 0

year 1

= 0

year 2

9 million investment done

year 3

cash flow starts

discounting is done with respect to the investment year (year 2)

hence

= 2.2/1.1 = 2

year 4:

2.2/(1.1)^2 = 1.818

year 5:

2.2/(1.1)^3 = 1.653

year 6:

2.2/(1.1)^4 = 1.503

Hence the total inflow = 6.974 million

we got the inflow present value at the year 2

total outflow = 9

NPV at year 2 is 6.974 - 9 = -2.026

since we waited for 2 years and no cash flow was there for those years, we need to discount the net to the present day ( at year 0 directly)

at year 0 the NPV is (-2.026)/(1.1)^2 = - 1.674

Similar way compute for 90% probability

here the cash flow is 4.2 million

compute the same way we get the NPV (for 90%) at year 0 as

3.564 million

Now compute with their respective probabilities

Here at 10% probability the NPV is negetive

Negetive NPV would never be considered for calculation

as per NPV rules.

Hence it will be taken as zero(at 10% probability)

0.10(0) + 0.9( 3.564) = 3.208 million

As you can see the cash flow by waiting period scenario is less than that of the initial scenario(company drills today).

Hence the company should drill today instead of waiting for 2 years.

c)

waiting period cash flow = 3.208

initial cash flow = 4.6794

Hence the value of option to delay = 46794 - 3.208 = 1.4714 million

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