The Engler Oil Company is deciding whether to drill for oilon 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 flowsof $4.3 million a year at the end of each of the next 4 years. Although the company is fairlyconfident about its cash flow forecast, it recognizes that if it waits 2 years, it will have moreinformation about the local geology as well as the price of oil. Engler estimates that if itwaits 2 years, the project will cost $12 million, and cash flows will continue for 4 years afterthe initial investment is made. Moreover, if it waits 2 years, there is a 95% chance that thecash flows will be $4.4 million a year for 4 years, and there is a 5% chance that the cash flowswill 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?
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 $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
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%.
a. If the company chooses to drill today, what is the project’s expected
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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