An integrated oil company is evaluating the exploration and development of an oil field. Initial investment of
Question:
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?
Fundamental financial accounting concepts
ISBN: 978-0078025365
8th edition
Authors: Thomas P. Edmonds, Frances M. Mcnair, Philip R. Olds, Edward