Question

1. Chapter MC, Section 14, Problems #13

Attempts
Drilling Experts, Inc.
Drilling Experts, Inc. (DEI) finds and develops of properties and then sels the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars.

t-0. A $400 feasibility study would be conducted at t-0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project.

t-1. If the feasibility study indicates good potential, the firm would spend $1,000 at t 1 to drill exploratory wels. The best estimate is that there is an 80% probability that the exploratory wells would indicate goed potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t-2. If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t-2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.
t-3. If the full diting program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow att 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflom.

Refer to the date for Drilling Experts, Incorporated. Since the project is considered to be quite risky, a 20% cost of capitat is used. What is the project's expected NPV, in thousands of dollars)
a. $507.22
b. $336.15
c. $373.50
d. $461.11
e. $415.00

Answer 1

a

Explanation:

Here are the cash flows at each stage:

t-0: -$400 (feasibility study cost)

t-1: -$1,000 (drilling exploratory wells cost)

t-2: -$10,000 (field estimation cost)

t-3: $25,000 (50% probability) or $10,000 (50% probability)

Now, let's calculate the present value (PV) of each cash flow:

PV(t-0) = -$400 / (1 + 20%)^0 = -$400

PV(t-1) = -$1,000 / (1 + 20%)^1 = -$833.33

PV(t-2) = -$10,000 / (1 + 20%)^2 = -$6,666.67

PV(t-3) = [$25,000 * 50% + $10,000 * 50%] / (1 + 20%)^3 = $15,000 / (1 + 20%)^3 = $9,090.91

Now, calculate the expected NPV by summing up the present values of the cash flows:

Expected NPV = PV(t-0) + PV(t-1) + PV(t-2) + PV(t-3)

Expected NPV = -$400 + (-$833.33) + (-$6,666.67) + $9,090.91

Expected NPV = $507.22 (approximately)

Therefore, the project's expected NPV is approximately $507.22 thousand dollars. Hence, the correct option is (a) $507.22.