Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells th

Question

Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars.

t = 0. A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project.

t = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells. The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t = 2. If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.

t = 3. If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow.

Refer to Exhibit 14.1. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project's expected NPV, in thousands of dollars?

A) $336.15

B) $373.50

C) $415.00

D) $461.11

E) $507.22

Explanation / Answer

D) $461.11

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