Question

3. Tin Can Oil Company is considering a sequential project. The first stage involves Tin Can leasing property today and conducting oil exploration for a total cost of $10 million. If the oil exploration isn’t promising, then Tin Can will abandon the project with $0 salvage value. If the results of the exploration are promising, then Tin Can will develop the property for oil extraction. The odds of the exploration producing promising results is estimated at 60%. In stage two, beginning a year from today, Tin Can will develop the property for oil extraction at a cost of $20 million. If oil prices are high, then the value of the oil extracted is estimated to be $60 million at the end of stage two. If oil prices are low, then the value of the extracted oil is more likely to be $30 million. Energy industry experts predict a 70% probability of high oil prices two years from today. Tin Can’s WACC is 10%.

   1. Diagram the decision tree for this project, indicating dates, cash flows, and probabilities.

   2. Compute the expected NPV for this project.

   3. What is Tin Can’s optimal decision for this project? Be as specific and detailed as possible.

Answer 1

Computation of expected values using the probabilitiees provided above

Cash outflow @ today for conducting oil exploration = $ 10 million

Cash Outflow @ 1 year later = $ 20 million * 0.60 probability = $ 12 million

Computation of Cost of developing based on the outflows after the end of year 2= $ 10 (1+1.10)^2 + $ 12 (1+1.10)

= $ 10(1.21) + 12(1.1)

= $ 12.1 + 13.2 = $ 25.3 million

Computation of inflows using probabilities = (Prob @ High price * High Value) + ((Prob @ Low price * Low Value)

= $60 * 0.70 + $ 30 * 0.30

= $ 42 + $ 9 = $ 51 million

Computation of NPV of the project = Cash inflows minus cash outflows

= $ 51 million - $ 25.3 million = $ 25.7 million

Since NPV is positive, it is optimal to start the project (ALL THE ABOVE VALUES ARE EQUATED TO THE END OF YEAR FOR COMPARISION)