The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will generate positive net 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, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $9 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $4.2 million a year for 4 years and a 10% chance that they would be $2.2 million a year for 4 years. Assume all cash flows are discounted at 8%. a. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places. $ 0.25 million b. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill? No, it makes sense to drill today.
The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will generate positive net 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, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $9 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $4.2 million a year for 4 years and a 10% chance that they would be $2.2 million a year for 4 years. Assume all cash flows are discounted at 8%. a. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places. $ 0.25 million b. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill? No, it makes sense to drill today.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Investment Timing Option: Decision-Tree Analysis
The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The
company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil
will generate positive net 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, in 2 years it will have more
information about the local geology and about the price of oil. Karns estimates that if it waits 2 years
then the project would cost $9 million. Moreover, if it waits 2 years, then there is a 90% chance that
the net cash flows would be $4.2 million a year for 4 years and a 10% chance that they would be $2.2
million a year for 4 years. Assume all cash flows are discounted at 8%.
a. If the company chooses to drill today, what is the project's net present value? Do not round
intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million
should be entered as 1.23, not 1,230,000. Round your answer to two decimal places.
0.25
million
$
b. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?
No, it makes sense to drill today.
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