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 $7 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $3.43 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 $8.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $3.78 million a year for 4 years and a 10% chance that they would be $1.82 million a year for 4 years. Assume all cash flows are discounted at 11%.

1. If the company chooses to drill today, what is the project's net present value? Negative value, if any, should be indicated by a minus sign. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places.
   $ ??? million

Answer 1

a)Calculation of Project's net present value(NPV)

Initial cash outlay=$7000,000

Net cash inflow for each year=$3430,000

Life of project=4 years

Discounting Rate=11%

Present value of Net cash inflow=Net cash inflow for each year*Present value Annuity factor @ 11% for 4 years

=$3430,000*3.1025

=$10641,575.00

Net Present Value=Present value of Net cash inflow-Initial cash outlay

=$10641,575.00-$7000,000

=$3641,575.00

=$3.64 millions

Thus,if the company chooses to drill today,the project's net present value is $3.64