The Enrico Oil Company is deciding whether to drill for oil on a tract. The company estimates that the project would cost $8 million today. The company estimates that once drilled, the oil will generate positive net cash flow of $4 million a year for the next 4 years. The company recognizes, however, that if it waits 2 years, it could cost $9 million, but there is a 90% chance that the next cash flow will be $4.2 million and there is a 10% chance that the net cash flow will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%.
The Enrico Oil Company is deciding whether to drill for oil on a tract. The company estimates that
the project would cost $8 million today. The company estimates that once drilled, the oil will
generate positive net cash flow of $4 million a year for the next 4 years. The company recognizes,
however, that if it waits 2 years, it could cost $9 million, but there is a 90% chance that the next
cash flow will be $4.2 million and there is a 10% chance that the net cash flow will be $2.2 million
a year for 4 years. Assume that all cash flows are discounted at 10%.
Required:
i. If the company opts to drill today, what is the project’s NPV?
ii. Evaluate whether it would be worthwhile to wait 2 years before deciding whether to
drill?
Step by step
Solved in 5 steps
