Question

Investment Timing Option: Decision-Tree Analysis The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $11 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $5.39 million a year at the end of each of the next 4 years. Although the company is fairly confident about its 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 $12.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $6.05 million a year for 4 years and a 10% chance that they would be $3.3 million a year for 4 years. Assume all cash flows are discounted at 11% a. If the company chooses to drill today, what is the project's net present value? A negative value should be entered with a negative sign. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. million b. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill? -Select-

Answer 1

a)

If the company chooses to drill today, the NPV can be calculated as
Year	Cash flow	PVIF(r,n)	Present Value
	(in millions)
0	-11	1	-11
1	5.39	0.900901	4.855856
2	5.39	0.811622	4.374645
3	5.39	0.731191	3.941122
4	5.39	0.658731	3.55056
		NPV	5.722182

Where PVIF(r,n) = 1/(1+r)ⁿ

and r= discount rate = 11% = 0.11 and

n= no. of year in which the cash flow occurs and

Present Value = Cash flow * PVIF(r,n)

NPV= sum of Present value of all cash flows

Hence, the NPV is 5.72 millions

b) If the company waits , the cash flows can be calculated as the expected cash flows in different situations

The expected Cash flows each year for year 1-4 can be calculated as  

= 90% * 6.05 million + 10%* 3.3 million

= 5.775 millions

Now, the NPV can be calculated as earlier

Year	Cash flow	PVIF(r,n)	Present Value
	(in millions)
2	-12.5	0.811622	-10.1453
3	5.775	0.731191	4.22263
4	5.775	0.658731	3.804171
5	5.775	0.593451	3.427181
6	5.775	0.534641	3.087551
		NPV	4.396253

Hence, the NPV in this case will be $4.40 million

As this NPV is less than the NPV when the company chooses to drill today, it doesn't make any sense to wait 2 years