F G H Digger Exploration, Inc. is considering an investment in a project that is expected to have a five-year life. The investment would require the Company to drill a well at a cost of $3.0 million Digger's hurdle rate is 20 percent. The expected outcomes as a result of the drilling are: High volume: 50% probability - could produce up to 725,000MMBtus each year for five years Medium volume: 30% probability - could produce up to 550,000MMBtus each year for five years Dry hole: 20% probabilty If the well is sucessful, the Company would have to make a decision as to whether to build a small or large processing plant. A large processing plant would cost $1,000,000 to construct and could process up to 710,000 MMBtus each year for five years. A small processing plant would cost $500,000 to construct and could process up to 525,000 MMBtus each year for five years The amount of gas that can be sold is also dependent on the favorability of the market. If the well proves to be good, the Company could sell up to 710,000 MMBtus each year for five years whereas a poor market will limit the Company's sales to an estimated 450,000 MMBtus each year for five years. The probabilities of the market type are as follows: High volume (Good Market): 75% Medium volume (Poor Market): 25% Finally, the price received is also dependent on the favorability of the market. The Company believes it will receive $2.75 per MMBtu in a good market but only $2.40 per MMBtu in a poor market. Required: 1. Calculate the NPVs for Options 1,2,3. & 4 2. Construct a decision tree, in good form, that lists the 10 possible outcomes. 3. What is your recommendation le should the Company drill the well? If so, what size of a processing plant do you recommend? What is the expected value of your recommendation? Data Amount Probability Period PVOA of $1 Rate 20.00% Item Capital costs: Drill well Build large processing plant Build small processing plant 3.000.000 1,000,000 500,000 Financial Factors Table LFV of $ 1 F VOA of $1 1.000000 1.200000 1.000000 1.440000 2.200000 3.640000 2.073600 5.368000 2.488320 7.441600 PV of $1 1.000000 0.833333 0.694444 0.578704 0.482253 0.401878 1.728000 0.833333 1.527778 2.106481 2.588735 2.990612 50% 725,000 550,000 30% 12 9 Volumes that can be produced: 10 High 11 Medium Dry hole 13 14 Volumes that can be processed: 15 Large plant 16 Small plant 20% Option Drill? Result 710,000 525,000 Small 18 Volumes that can be sold in a: 19 Good market 20 Poor market Summary Volume? Plant? High Large High Large High Small Medium Large Medium Large Medium Medium Small Dry hole Market? Good Poor Good Poor Good Poor Good 3 Yes 4 Yes 5 Yes 6 Yes 7 Yes 8 Yes 9 Yes 10 No 710,000 450,000 252 Small 523,301 (770,139) 817,696 (270,139) (3,000,000) Poor 2.75 NA 22 Unit prices in a: 23 Good market 24 Poor market 25 26 (END) 2.40 NA NA
