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Homework answers / question archive / The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns
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 $13 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $6.37 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 $14 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $6.89 million a year for 4 years and a 10% chance that they would be $3.64 million a year for 4 years.
Assume all cash flows are discounted at 12%. If the company chooses to drill today, what is the project's net present value? Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?
To solve this problem, we will make use of the following formula:
NPV=−CF0+CF11+r+CF2(1+r)2....CFn(1+r)nNPV=−CF0+CF11+r+CF2(1+r)2....CFn(1+r)n
The problem states that the estimated project cost is $13 million. This becomes the initial cost in the NPV calculation. In addition, the problem states the company's discount rate is 12% annually.
Begin by calculating the NPV of Option 1: Drill now.
Applying the NPV formula above, the NPV of Option 1 is:
NPV=−$13,000,000+6,370,0001+0.12+6,370,000(1+0.12)2+6,370,000(1+0.12)3+6,370,000(1+0.12)4=$6,347,915NPV=−$13,000,000+6,370,0001+0.12+6,370,000(1+0.12)2+6,370,000(1+0.12)3+6,370,000(1+0.12)4=$6,347,915
To calculate the NPV of Option 2, two steps are required. First, calculate the NPV of the project. This provides the NPV in 2 years' time. Then, discount the NPV an additional 2 years to today's date in order to provide a direct comparison with the NPV for Option 1.
To calculate the net cash flows for Option 2, multiply the expected cash flows by their respective probabilities and add them together as follows:
Cashflow=(0.9)($6,890,000)+(0.1)($3,640,000)=$6,565,000Cashflow=(0.9)($6,890,000)+(0.1)($3,640,000)=$6,565,000
Then, using the formula above, calculate the NPV of Option 2 in 2 years:
NPV=−$14,000,000+6,565,0001+0.12+6,565,000(1+0.12)2+6,565,000(1+0.12)3+6,565,000(1+0.12)4=$5,940,198NPV=−$14,000,000+6,565,0001+0.12+6,565,000(1+0.12)2+6,565,000(1+0.12)3+6,565,000(1+0.12)4=$5,940,198
Further discounting 2 years, the NPV of Option 2 today is:
NPV=5,940,198(1+0.12)2=$4,735,489NPV=5,940,198(1+0.12)2=$4,735,489
Therefore, Option 1 has the higher NPV and Karns Oil should drill today.
