The Karns Oil Company is deciding whether to drill for oil on a tract of land 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 10%

a. If the company chooses to drill today, what is the project’s net present value?

b. Using decision-tree analysis, does it make sense to wait 2 years before deciding

whether to drill?

Answer:

Initial Investment: $ 8 Million

Cash Flow: $ 4 Million

Life Project: 4 Years

Discounted Rate : 10% (1+0,10)= 1,10

Problems: If the company chooses to drill today, what is the project’s net present value?

Year PV

1 4/(1+0.10)1=4/(1,100) 3,694

2 4/(1+0.10)2 =4/(1,210) 3,3058

3 4/(1+0.10)3 =4/(1,331) 3,0053

4 4/(1+0.10)4 = 4/(1,464) 2,7321

Total 12,6795

NPV=-20 + 12,6754 =4,6795 Million

Answer B:

Cost Project: 9 Million

Low Cash Flow Prob 10%= 2,2 Million for 4 years

High Cash Flow Prob 90%= 4,2 Million for 4 years

Discounted Rate= 10% (1+0,10)= 1,10

Wait for years= 2 years

Problems: Using decision-tree analysis, does it make sense to wait 2 years before deciding

whether to drill?

Wait 2 Years

Low 10% Prob High 90% Prob

Year NPV NPV

0 0 - 0 -

1 0 - 0 -

2 -9 Million -9 Million -

3 2,2/(1,10)1 2 4,2/(1,10)1 4

4 2,2/(1,10)2 1,818 4,2/(1,10)2 3,471

5 2,2/(1,10)3 1,653 4,2/(1,10)3 3,156

6 2,2/(1,10)4 1,503 4,2/(1,10)4 2,869

Total 6,974 Total 13,313

Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674

High CF scenario: NPV = (-9 + 13.313)/(1.1)2 = $3.564

Expected NPV = .1(-1.674) + .9(3.564) = 3.040

If the cash flows are only $2.2 million, the NPV of the project is negative and, thus, would

not be undertaken. The value of the option of waiting two years is evaluated as 0.10($0) +

0.90($3.564) = $3.208 million.

Since the NPV of waiting two years is less than going ahead and proceeding with the project

today, it makes sense to drill today.