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Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project would cost $8 million today. Karns estimates that once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 5 years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 3 years, it would have more information about the local geology as well as the price of oil. Karns estimates that if it waits 3 years, the project will cost $12 million. Moreover, if it waits 3 years, there is a 90% chance that the net cash flows will be $4.2 million a year for 5 years, and there is a 10% chance that the cash flows will be $2.2 million a year for 5 years. Assume that all cash flows are discounted at 10%.

a. If the company chooses to drill today, what is the project's net present value?

b. Using decision tree analysis, does it make sense to wait 3 years before deciding whether to drill?

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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