The Karns Oil Company is deciding whether to drill for oil on a tract of land th

Question

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 $3.15 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 $10 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $3.71 million a year for 4 years and a 10% chance that they would be $2.03 million a year for 4 years. Assume all cash flows are discounted at 11%.

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

Explanation / Answer

If the company chooses to drill today, project's NPV= $3.15 million * PVAF(11%,4 years) - $7 million

NPV=  $3.15 million * 3.102446 - $7 million = 9.77-7= 2.77

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