East Texas Energy Inc (ETE) is considering a investing in a new oil reserve. The project will cost $71 million up front and is expected to generate cash flows during each of the following three years, with the amount of cash flow directly related to oil prices. ETEs finance department has forecast three likely scenarios for oil prices. There is a 10% probability that oil prices will increase, with associated FCF of $40 million per year for three years. There is a 80% probability that oil prices will remain near current levels, with associated FCF of $30 million per year for three years. The third possibility is a 10% probability that oil prices will decline, with associated FCF of $20 million per year for three years. ETE has determined that the required rate of return for this project is 15%.

Now assume that the finance department has re-estimated the probabilities of the three oil price scenarios. All of the other project data will be unchanged. The re-vised probabilities are 40% chance of oil prices increasing, 20% probability of oil prices remaining at current levels, and a 40% probability of oil prices declining.

5. Compute the Expected NPV of the new oil reserve without the growth option (i.e. replicate question one, but with the new probabilities).

6. Compute the Expected NPV of the new oil reserve with the growth option (replicate question 2 using the new probabilities).

7. Compute the value of the Real Option embedded in this project.

8. Should ETE accept or reject the project?