The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $6 million today. Bush estimates that once drilled, the oil will generate positive cash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project will cost $8 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 70% chance that the cash flows will be $4.3 million a year for 4 years, and there is a 30% chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 9%.

If the company chooses to drill today, what is the projects expected net present value? Expected NPV = million (to 4 decimals)

Would it make sense to wait 2 years before deciding whether to drill? Explain.

NPV of waiting

million (to 4 decimals)

(yes or no), because the NPV of waiting two years is (less or greater) than going ahead and proceeding with the project today.

What is the value of the investment timing option? $ million (to 4 decimals)

What disadvantages might arise from delaying a project such as this drilling project?