Question

1. Your midrange guess to the amount of oil in a prospective field is 10 million barrels, but in fact there is a 50% chance that the amount of oil is 15 million barrels and a 50% chance that it is 5 million barrels. If the amount is only 5 million then the present value of cash flows is $2 million. If the amount is 15 million barrels, the present value of cash flows will be $8 mill. IT costs $3 million to drill the well.
   1. Should you accept the project?
   2. IF a seismic tests which cost $200,000$ can verify the amount of oil, is it worth paying for the test?

Answer 1

(a) PV of Possible Cash Flows: $2 million if the amount of oil is 5 million barrels. $ 8 million of the amount of oil is 15 million barrels

Probability of Each Option: 0.5

Expected PV of Cash Inflow = 0.5 x 2 + 0.5 x 8 = $ 5 million

Initial Investment = Drilling Costs = $ 3million

NPV = 5 - 3 = $ 2 million

As the project has positive NPV the same should be accepted.

(b) Seismic test is an additional cost which has to be undertaken to determine the amount of oil and hence the expected cash inlfows. Therefore, it is not a sunk cost as this cost will be borne only when one is sure of going ahead with this project.

Hence, NPV in this case = 5 - (3+0.2) = $ 1.8 million

As the NPV of the project is positive even after undertaking the test, then it is worthwhile to take the test.