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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

INVESTMENT TIMING OPTION The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $8 million today. Bush estimates that once drilled, the oil will generate positive cash flows of $4 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 more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project will cost $9 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 90% chance that the cash flow's will be $2.2 million a year for 4 years, and there is a 10% chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%.

  1. a. If the company chooses to drill today, what is the project’s expected net present value?
  2. b. Would it make sense to wait 2 years before deciding whether to drill? Explain.
  3. c. What is the value of the investment timing option?
  4. d. What disadvantages might arise from delaying a project such as this drilling project?

a.

Summary Introduction

To Determine: The expected net present value if the company chooses to drill today.

Introduction: The net present value is also termed as the discounted cash flow approach is a mainstream capital budget method that considers the time value of cash. It utilizes net present value of the investment as the base to accept or reject a projected investment in projects like buying of new machine, buying of stock or inventory etc.

Explanation

Determine the net present value

Using a excel spreadsheet, the net present value is determined as $4,679,461.79.

Excel Spreadsheet:

b.

Summary Introduction

To Determine: Whether it would make sense to wait for 2 years before deciding to drill.

c.

Summary Introduction

To Determine: The value of investment timing option.

d.

Summary Introduction

To Determine: The disadvantage that might arise from delaying a project.

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