Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.24 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.12 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as w

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Question:

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.24 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.12 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.59 million. Moreover, if it waits two years, there is a 85% chance that the cash flows would be $2.306 million a year for four years, and there is a 15% chance that the cash flows will be $0.705 million a year for four years. Assume that all cash flows are discounted at a 8% WACC. Will the company delay the project and wait until they have more information

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Answer:The company will invest now and not delayExplanation:In order to determine the better option, we have to determine the Net present value of each of the option.Net present value is the present value of after-tax cash flows from an investment less the amount invested.  NPV can be calculated using a financial calculator The option with the higher NPV would be chosen  First option Cash flow in year 0 = $-4.24 million Cash flow in year 1 = $2.12 million Cash flow in year 2 = $2.12 million Cash flow in year 3 = $2.12 million Cash flow in year 4 = $2.12 millionI = 8%NPV = 2.78 millionSecond optionNPV of the cash flow with $2.306 million a year for four yearsCash flow in year 0 = 0 Cash flow in year 1 = 0  Cash flow in year 2 = $-4.59 million. Cash flow in year 3 = $2.306 Cash flow in year 4 = $2.306 million Cash flow in year 5 = $2.306 million Cash flow in year 6 = $2.306 million I = 8 NPV = $2.61 millionNPV when cash flows would be $0.705 million Cash flow in year 0 = 0 Cash flow in year 1 = 0 Cash flow in year 2 = $-4.59 million. Cash flow in year 3 = $0.705 million Cash flow in year 4 = $0.705 million Cash flow in year 5 = $0.705 million Cash flow in year 6 = $0.705 million I = 8 % NPV = -1.93 millionNPV of the second option = (0.85 x $2.61 million) + (0.15 x 0) = $2.22 millionThe NPV when cash flows would be $0.705 million is zero because the NPV is negative and thus would not be undertaken. The company will invest now and not delay because the NPV of not waiting is greater than the NPV of delaying To find the NPV using a financial calculator: 1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction. 2. after inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.  3. Press compute  

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