Textbook Problem

INVESTMENT TIMING OPTION The Engler 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 $9 million today. Engler estimates that once drilled, the oil will generate positive cash flows of $43 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. Engler estimates that if it waits 2 years, the project will cost $12 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that the cash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flows will be $2.4 million a year for 4 years. Assume that all cash flows are discounted at 11%.

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. 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?