Investment Timing Option: Decision-Tree Analysis The Karns Oil Company is decidi

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 $9 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $4.05 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 $10.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $4.68 million a year for 4 years and a 10% chance that they would be $2.43 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

The company holds a real option in its hands i.e it can decide whether to drill or not after 2 years depending on the information from local geology and the prices of oil.

The question asks us to calculate the NPV ( Net Present Value ) of the project if the company deicides to drill today.

The initiall cost (C0) would be $9 million and the net cash flow for next 4 years (C1, C2, C3, C4) would be $4.05 million. The discount rate (d) is 11%.

NPV = - C0 + C1/(1+d) + C/(1+d)2 + C/(1+d)3 + C/(1+d)4

NPV = - 9 + (4.05 /1.11) + (4.05/1.112) + (4.05/1.113 )+ (4.05/1.114)

NPV = - 9 + (4.05/1.11) + (4.05/1.23) + (4.05/1.37) + (4.05/1.52)

NPV = $ 3.57 million

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.