The Engler Oil Company is deciding whether to drill for oil on a tract of land that

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The Engler Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $9 million today. Engler estimates that once drilled, the oil will generate positive cash flows of $4.3 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have more information about the local geology as well as the price of oil. Engler estimates that if it waits 2 years, the project will cost $12 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that the cash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flows will be $2.4 million a year for 4 years. Assume that all cash flows are discounted at 11%. 

a. If the company chooses to drill today, what is the project’s expected net present value?
b. Would it make sense to wait 2 years before deciding whether to drill? Explain.
c. What is the value of the investment timing option?
d. What disadvantages might arise from delaying a project such as this drilling project?

Net Present Value
What is NPV? The net present value is an important tool for capital budgeting decision to assess that an investment in a project is worthwhile or not? The net present value of a project is calculated before taking up the investment decision at...
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Related Book For  book-img-for-question

Fundamentals of Financial Management

ISBN: 978-1337395250

15th edition

Authors: Eugene F. Brigham, Joel F. Houston

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