Question

The Aaron Oil Company is deciding whether to drill for oil on a tract of land the company owns. The company estimates the project would cost $10 million today. Aaron estimates that, once drilled, the oil will generate positive net cash flows of $3.4 million a year at the end of each of the next 5 years. Although the company is fairly confident about its cash flow forecast, in 1 years it will have more information about the local geology and about the price of oil. Aaron estimates that if it waits 1 year then the project would still cost $10 million. Moreover, if it waits 1 year, then there is a 80% chance of favorable market conditions that the net cash flows would be $4.0 million a year for 5 years and a 20% chance of unfavorable market conditions that they would be $1.0 million a year for 5 years. Aaron will know which of these cash flows will occur when it makes the decision whether to invest at Year 1. Assume all cash flows are discounted at 10%.

If the company chooses to drill today, what is the project’s net present value? (in million dollars)

		$2.11
		$2.89
		$3.12
		$3.37
		$3.56

Using information from Question 14. Using decision-tree analysis, how much is the project’s expected NPV if Aaron waits 1 year before deciding whether to drill? (in million dollars)

		$4.89
		$4.25
		$3.45
		$3.76
		$3.89

Answer 1