Question

6. (2.5 pts) (Note: show your work, do not use excel) An integrated oil company is evaluating the exploration and development of an oil field. Initial investment of $100 mil is needed for start-up costs.

After a year of start-up, three levels of oil are expected to be uncovered. There is a 20% chance of getting a high level with expected annual FCFF of $25 mil for 20 years; a 60% chance that annual FCFF will be $15 mil for 20 years; and a 20% chance that the operation will be unsuccessful and produce $-6 mil annual FCFF for 20 years. (Note all the expected FCFFs start from year 2.) Assume the cost of capital is 10%.

A. What is the NPV of the project ignoring any option?

B. If project can be abandoned at the end of the start-up phase after the outcome is revealed, what is the NPV with this abandon option?  Assuming the cost of shutting down the operation is $5 million.

C. What is the value of the option?

Answer 1

(A) Calculation of  NPV

Expected cash inflow ( FCFF) from 2- 20 year = 0.20 * $ 25 m + 0.60 * $ 15 m + 0.20 * $ 6 m   = $ 15.2 million

( amount in $ millions)

Year	cash flow	cumulative pv factor @ 10%	present value
0	(100)	1.00	(100)
1	0	0.909	0
2-20	15.2	7.605	115.6
		NPV	$ 15.60 million

(B) If project abondonded after end of start up phase when outcome is revealed with shut down cost $ 5 million then NPV -

If it is assumed that shut down cost incurred at t0

NPV = (100) + (5) = $ (105) million

If it is assumed that shut down cost incurred at t1

NPV = (100) *1 + (5) * 0.909 = $ 104.545 million

(C) Value of option is the cost of investment and cost of shutting down the opration show in above (B)