Question

"Trey Jackson, CFO of Jackson Exploration, Inc. is deciding how to approach a particular oil well project. If the company drills today, the project would cost $925,000 today, and would provide estimated cash flows of $600,000 per year at the end of each of the next 4 years. However, if the company waits a year before drilling, the company would have more geological information regarding the well’s possibilities. The company estimates that if it waits 2 years, the project would cost $975,000 and would have a 65 percent chance of having net cash flows of $1,000,000 per year for 4 years, and a 35 percent chance of having net cash flows of only $300,000 per year for 4 years. Assume a discount rate of 17.5 percent. What should the company do

Answer 1

the NPV of drilling in two more years is $74,430 higher in current dollars than drilling today

Step-by-step explanation:

we can assume that these are 2 different projects:

project A:

initial outlay -$925,000

CF 1 $600,000

CF 2 $600,000

CF 3 $600,000

CF 4 $600,000

discount rate = 17.5%

NPV = -$925,000 + $600,000/1.175 + $600,000/1.175² + $600,000/1.175³ + $600,000/1.175⁴ = $704,859

project B (in two years):

initial outlay -$975,000

CF 1 = ($1,000,000 x 65%) + ($300,000 x 35%) = $755,000

CF 2 = $755,000

CF 3 = $755,000

CF 4 = $755,000

discount rate = 17.5%

NPV = -$975,000 + $755,000/1.175 + $755,000/1.175² + $755,000/1.175³ + $755,000/1.175⁴ = $1,075,906 in two years

now we need to discount the NPV ⇒ $1,075,906/1.175² = $779,289

the NPV of drilling in two more years is $74,430 higher in current dollars than drilling today = $779,289 - $704,859 = $74,430