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The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that 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.
While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it would have more information about the local geology as well as the price of oil. Karns estimates that if it waits 2 years, the project would cost $9 million. Moreover, if it waits 2 years, there is a 90 percent chance that the net cash flows would be $4.2 million a year for 4 years, and there is a 10 percent chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10 percent.
a. If the company chooses to drill today, what is the project's net present value?
b. Using decision tree analysis, would it make sense to wait 2 years before deciding whether to drill?
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