Question

Quantitative Problem 2: Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.33 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.165 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.93 million. Moreover, if it waits two years, there is a 70% chance that the cash flows would be $2.328 million a year for four years, and there is a 30% chance that the cash flows will be $0.789 million a year for four years. Assume that all cash flows are discounted at a 8% WACC. What is the project's net present value in today's dollars, if the firm waits two years before deciding whether to drill? million (to 5 decimals)

Answer 1

NPV= C0+Sum of Probability*PV of annuity

PV of annuity = Annuity*(1-1/(1+rate)^number of terms)/rate

PV of $2.328 m = 2.328*(1-1/1.08^4)/0.08 =

7.710631

PV of $0.789 m = 0.789*(1-1/1.08^4)/0.08 =

2.613268

NPV = -4.93+70%*7.710631+30%*2.613268 = 1.25142 million