Quantitative Problem :
Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.8 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.4 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $5.47 million. Moreover, if it waits two years, there is a 85% chance that the cash flows would be $2.598 million a year for four years, and there is a 15% chance that the cash flows will be $1.461 million a year for four years. Assume that all cash flows are discounted at a 8% WACC.
What is the project’s net present value in today’s dollars, if the firm waits two years before deciding whether to drill?
$ million (to 5 decimals)
Additional info...
Layout the timeline for the project’s cash flows including the initial cost of the project and the 4 years of positive cash flows generated.
Realize that the project’s initial cost occurs at the end of Year 2, so you will have zero cash flows in Years 0 and 1, the initial cash outlay in Year 2, and then positive cash flows in Years 3 through 6. If the timeline is set up in this way, you will be calculating the project’s NPV today.
You will have 2 different timelines (good outcome and bad outcome) with the probability of each specified.
Calculate the NPV of each timeline branch and then weight the NPV by the probability of each outcome. Realize that if the NPV of one of the branches is negative then the relevant NPV for that branch is zero as the project would not be undertaken if the NPV is negative.