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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
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?

a.

Summary Introduction

To determine: The expected net present value (NPV) of the project.

Introduction:

NPV is the variation between the present value of the cash outflows and the present value of the cash inflows. In capital budgeting, the NPV is utilized to analyze the profitability of a project or investment.

Explanation

Given information:

E Company has decided to drill for oil on a land of the company. This project estimated a cost of $9,000,000 and would make positive cash flows of $4,300,000 at the end of each next 4 years.  The company has even estimated that when their wait for 2 years more, then the project would cost $12,000,000 and cash flows will continue for 4 years.

There is 95 percent probability that the cash flows will be $4,400,000 for 4 years when the company waits for two years and 5 percent probability that the cash flows will be $2,400,000 for 4 years. The entire cash flows are discounted at 11 percent...

b.

Summary Introduction

To determine: Whether it makes sense to wait for 2 years before drilling.

c.

Summary Introduction

To determine: The value of the investment timing option.

d.

Summary Introduction

To discuss:  The disadvantage on delaying a project.

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