An oil drilling project costs us, $60,000 for sinking a well, $150,000 to purchase equipment and $50,000 to install them. Also, the pumping equipment will entail annual on-going operating and monitoring cost of $100,000 per year. We will be able to pump out 4,000 barrels of oil per year over the next two years. The current price for a barrel of oil is $46 with the volatility of either rising by 25 percent or dropping by 25 percent per year over the next two years. Cost of sinking the well is sunk, but the pumping equipment can always be sold and deployed elsewhere, but this equipment will deteriorate over time. Specifically, after a year of use, it will only be worth $140,000 and after two years of use it will be worth $40,000.
The cost of the equipment and sinking the well are incurred at t=0. Since it will take a year to get the well up and running. We will not get any revenue at t=0. The first time it will get any revenue is at t=1 (one year from now). The annualized risk-free rate is 0.01.
1. At t = 0, what is the present value of the cash flows generated by this project if you exercise your abandonment options optimally?
2. What is the net present value of sinking the well and installing the equipment at t = 0? Should you sink the well? Explain why.