INVESTMENT TIMING OPTION The Engler Oil Company is deciding whether to drill for oi on a tract of land that the company owns. The company estimates that the project will cos $9 million today. Engler estimates that once drilled, the oil will generate positive cash flow of $4.3 million a year at the end of each of the next 4 years. Although the company is fairl confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have mor information about the local geology as well as the price of oil. Engler estimates that if waits 2 years, the project will cost $12 million, and cash flows will continue for 4 years afte the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that th cash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flow 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?
INVESTMENT TIMING OPTION The Engler Oil Company is deciding whether to drill for oi on a tract of land that the company owns. The company estimates that the project will cos $9 million today. Engler estimates that once drilled, the oil will generate positive cash flow of $4.3 million a year at the end of each of the next 4 years. Although the company is fairl confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have mor information about the local geology as well as the price of oil. Engler estimates that if waits 2 years, the project will cost $12 million, and cash flows will continue for 4 years afte the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that th cash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flow 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?
Managerial Accounting
15th Edition
ISBN:9781337912020
Author:Carl Warren, Ph.d. Cma William B. Tayler
Publisher:Carl Warren, Ph.d. Cma William B. Tayler
Chapter12: Capital Investment Analysis
Section: Chapter Questions
Problem 21E: Net present value-unequal lives Bunker Hill Mining Company has two competing proposals: a processing...
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Transcribed Image Text:INVESTMENT TIMING OPTION The Engler Oil Company is deciding whether to drill for oi
on a tract of land that the company owns. The company estimates that the project will cos
$9 million today. Engler estimates that once drilled, the oil will generate positive cash flow
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 mor
information about the local geology as well as the price of oil. Engler estimates that if
waits 2 years, the project will cost $12 million, and cash flows will continue for 4 years afte
the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that th
cash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flow
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?
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