Reference no: EM132607259

Fair Oil owns a tract of land that may be rich with oil. Fair must decide whether or not to drill on this land. Fair estimates that the project would cost $25 million today (t = 0), and generate positive net cash flows of $10 million a year at the end of each of the next four years (t = 1, 2, 3, and 4.

Question a) If the company chooses to drill today, what is the project's net present value (NPV)?

While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 1 year, it would have more information about the local geology and the price of oil. Fair estimates that if it waits one year, the project will cost $26 million (at t = 1). If Fair Oil waits a year, there is an 80% chance that market conditions will be favorable, in which case the project will generate net cash flows of $12 million a year for four years (t =2, 3, 4, and 5). There is a 20% chance that market conditions will be poor, in which case the project will generate net cash flows of $2 million a year for four years (t = 2, 3, 4, and 5). After finding out the market conditions at t = 1, Fair will then decide whether to invest in the project (i.e., it is not obligated to undertake the project). Assume that all cash flows are discounted at 10 percent.

Question b) Fair must decide if it makes sense for the company to wait a year to drill. If it waits a year, what would be the expected net present value (NPV) at t = 0? (HINT: If market conditions are poor at t=1, the firm will not implement the project, so the probabilities and cash flows associated with the poor conditions are irrelevant and can be ignored)

Question c) What is the value of the timing option?