Deep Sea Drilling is evaluating drilling for oil in the Gulf of Mexico. It will cost $830 million to buy an oil rig. Drilling would start immediately. The company has a cost of capital of 11%.

There is a 50% probability that the new well will be succcessful, in which case the free cash flow from the well will be $200 million per year for 20 years. Otherwise, it will only generate $40 milion per year for 10 years.

What is the NPV of the project (in $ million)?

Correct

Success:

NPVsuccess=CF0+CFKW(11(1+KW)N)success=0+(1-1(1+))

= 830+2000.11(11(1+0.11)20)=762.67-830+2000.11(1-1(1+0.11)20)=762.67

Failure:

NPVfailure=830+400.11(11(1+0.11)10)=594.43failure=-830+400.11(1-1(1+0.11)10)=-594.43

Expected NPV:

E(NPV)=psuccessNPVsuccess+pfailureNPVfailure()=successsuccess+failurefailure

= 0.5762.67+(10.5)594.430.5762.67+(1-0.5)-594.43

= 84.12 (million)

a.In fact, the company can abandon the project after the first year and sell the oil rig for $664 million. What is the NPV of the project now (in $ million)?

b.What is the value of the option (in $ million)?