Reference no: EM132951812

Depending on the adoption of shale gas extraction technology in Poland and Ukraine, world natural gas prices will be either high or low in each of the years 2013- 2016. If they are high, prices will be $0.2 per cubic meter in 2013 and grow at 5% each year. If they are low, prices will be $0.1 per cubic meter in 2013 and grow at 5% each year. The probability of prices being high is 40%.

Today (2012) you are considering purchasing a license from the Russian government to extract natural gas from reserves in Siberia. These reserves can yield 10 billion cubic meters per year for at least 10 years; however, the license will expire after 2016. The variable costs (extraction) are $0.08 per cubic meter.

In addition to the variable costs, you need to install a pipeline to transport natural gas from your place of extraction to the buyers. This pipeline will cost $3 billion, and the installation must begin today (2012) in order to finish it in time to extract gas in 2013. At the end of 2016 you estimate that you will be able to sell this pipeline to the Russian government for $2 billion. The Russian government allows you to use straight line depreciation on this pipeline. The corporate tax rate is 30% and your average cost of capital is 11%.

Suppose you could wait for a year to see whether Poland and Ukraine are successful in adopting shale gas extraction technology. You would still need to buy the license today, but you could choose to build or not build the gas pipeline next year (2013). If you choose to build it next year, you will only start extracting gas the following year (2014). The cost and resale price of pipeline remains as before. How would your answer to (a) change?