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 $7 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $3.5 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 $8 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $3.78 million a year for 4 years and a 10% chance that they would be $2.1 million a year for 4 years. Assume all cash flows are discounted at 12%.

1. If the company chooses to drill today, what is the project's net present value? Negative value, if any, should be indicated by a minus sign. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places.
   $     million

Answer 1

a). Solution :- Net present value of project = Present value of cash inflows - Present value of cash outflow.

Present value of cash inflows = 3.50 Million * Cumulative present value factors for the four years at a discount rate of 12 % (using the present value table)

= 3.50 million * 3.0373 (approx).

= $ 10.63055 Million.

Present value of cash outflow (Cost of project) = $ 7 Million.

Accordingly, Net present value of project = 10.63055 Million - 7 Million.

= $ 3.63055 Million. (Rounded off to $ 3.63 Million)

Conclusion :- Net present value of project (if drill done by company on today) = $ 3.63 Million. (approx).