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 $11 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $5.06 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 $13.5 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $5.72 million a year for 4 years and a 10% chance that they would be $3.08 million a year for 4 years. Assume all cash flows are discounted at 11%. If the company chooses to drill today, what is the project's net present value?
When deciding whether to begin a project now, management have to consider the possibility of delaying this project until more favorable conditions exist or more information is available. They can do that either by incorporating the cash flows of the future project as an opportunity cost in today's decision or by computing the NPV's of the two alternatives separately and then selecting the one with the higher NPV.
Answer and Explanation:
We will first compute the NPV of starting the project today. Its relevant cash flows are:
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from Financial Accounting: Help and ReviewChapter 4 / Lesson 1