You’ve struck oil in Texas! However, the terrain is tricky and the upfront cost (immediate cost) of extracting with current technology is $38 million. You’ve also heard of a new extraction technology being developed at UGA. There is an 80% chance that this technology will be successful and ready to use in exactly one year. If it’s not ready in one year (20% chance), then it will never be ready. The new technology is expected to reduce the extraction cost to $16 million. If you decide to wait, you will have to pay $5 million to the landowner as a fee to prevent other oil companies from trying to drill on the land. This payment would be due at the end of the year. You also know the following:

• 1. You can extract 100,000 barrels every year forever once you pay the upfront extraction cost
• 2. The price of a barrel of oil is expected to be $50 at the end of this year and is expected to fall by 4% every year forever. All revenues are realized at the end of the year.
• 3. There are no extraction costs other than the upfront cost
• 4. Your opportunity cost of capital is 10%Q

-What is the NPV of the project if you decide to drill today?

-What is the NPV of the project if you decide to wait one year?

Answer rating: 100% (QA)

1 If you decide to drill today the NPV of the project is 18052632 2 If ... View the full answer