Reference no: EM132797228

Question - Capital budgeting with real options. Estonian Oil Company (EOC) is evaluating the feasibility of pumping oil in a newly discovered oil well in Lake Peipsi. The company estimates that today the investment in the project would amount to 75 million euros. The company estimates that the positive cash flow after the construction of the drilling tower will be EUR 35 million per year over the next four years. Although the company is quite confident in its forecasts, in two years time it would be possible to say more precisely, what the actual impact of this project will be on the local environment and the quality and price of the oil being pumped. Therefore, the company could postpone the investments for two years. The company predicts that investment in the project (if postponed) is expected to increase to EUR 90 million in two years' time. There is an 80% probability that the annual positive cash flow is going to be EUR 50 million and with a 20% probability the cash flow could be as low as EUR 22 million a year for every subsequent four years. It would be known in two years what scenario will start. The Estonian Oil Company has also entered into negotiations with Rosneft, which suggests that drilling rights for oil pumping may be sold to Rosneft in after two years for EUR 12 million. Of course, if you sell drilling rights, you can no longer drill yourself. The cost of capital is 10%

Required -

a) If the company decides to drill immediately, what will be the net present value (NPV) of the project?

b) Should the EOC wait two years and then decide whether or not to start drilling for oil or to sell the drilling rights instead? You can illustrate the results of your analysis by drawing a decision tree (however, drawing a decision tree is optional)

c) Does this project includes any applications of real options? Explain.