Question

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 $4.14 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 $11.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $4.86 million a year for 4 years and a 10% chance that they would be $2.61 million a year for 4 years. Assume all cash flows are discounted at 12%. 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

Answer 1

NPV if the company chooses to drill today.

Cash flows C = $4.14 million

Number of years N = 4

Initial Investment CF0 = $9 million

Discount rate r = 12%

NPV = - 9 + Present value of all the cash flows

NPV = - 9 + C / ( 1+ r) + C / ( 1+ r)^2 + C / ( 1+ r)^3 + C / ( 1+ r)^4

NPV = - 9 + 4.14 / 1.12 + 4.14 / 1.12^2 + 4.14 / 1.12^3 + 4.14/1.12^4

NPV = - 9 + 3.69642857 + 3.30038265 + 2.94677023 + 2.63104485

NPV = - 9 + 12.57462630

NPV = 3.5746262950

NPV is $3.57 million