Problem 1:

SleazeCo. has a plot of land that geologists have indicated has a pool of crude oil under it.Estimates indicate that it will cost $200,000 to sink a well.In addition to the cost of sinking the well, SleazeCo will need to install pumping equipment.The cost of installing the equipment is $100,000 and the equipment itself will cost another $200,000.The pumping equipment will entail annual on-going operating and monitoring costs of $150,000 per year.With the well and the pumping equipment, SleazeCo. will be able to pump out 3,000 barrels of oil per year over the next two years.The current price for a barrel of crude oil is $100.But, there is uncertainty regarding what the prices will be in the future.Based on past experience and forecasts of future world prices, the volatility of crude oil is such that prices will either rise by 20 percent or drop by 10 percent per year over the next two years.While the cost of sinking the well is sunk (no pun intended) once the well has been sunk, the pumping equipment can always be sold and deployed elsewhere; but this equipment will deteriorate over time.Specifically, after a year of use, it will only be worth $160,000 and after two years of use it will be worth $50,000.

You need to analyze whether SleazeCo should sink the well and invest in pumping equipment now.The cost of the equipment and sinking the well are incurred at t = 0.Since it will take a year to get the well up and running, SleazeCo will not get any revenue at t = 0.The first time it will get any revue is at t = 1 (one year from now).The annualized risk-free rate is .05.

Questions:

1.using the options tree, show the net incomes (revenue minus operating costs) that are possible over the next two periods.(3 points)

t = 0t = 1t = 2

2.a.If you end up at the top node at t=1, what is the value of continuing to t = 2?Assume that if you continue, you will get the net income in the next period and the (depreciated) value of the equipment at the end of t =2.(3 points)

2.b.Should you continue if you end up at the top node at t = 1 or should you shut down the well and sell the equipment at t = 1?Circle one.(1 point)

ContinueSalvage

Explain why.

3.a.If you end up at the bottom node at t= 1, what is the value of continuing to t = 2?Assume that if you continue, you will get the net income in the next period and the (depreciated) value of your equipment at the end of t =2.(3 points)

3.b.Should you continue if you end up at the bottom node at t = 1 or should you shut down the well and sell the equipment at t = 1?Circle one.(1 point)

ContinueSalvage

Explain why.

1. At t = 0, what is the present value of the cash flows generated by this project if you exercise your abandonment options optimally?(2 points)

1. Should you start this project at t=0?That is, should you sink the well, install the equipment, and start extracting oil at t = 0?(2 points)

1. In this case, what is the value of the abandonment option?(2 points)