Petroleum Inc. (PI)controls offshore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10 percent per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Calculate today's NPV of the project if it were postponed by one year.
A)+$100 million
B)+$154 million
C)+$170 million
D)+$187 million

Question

Quizplus · Accepted Answer

If the project were postponed by one year, the project would be evaluated using the risk-free rate of 10% and the expected oil price of $100/bbl. The expected revenue would be:

Expected revenue = (1,200,000 bbl.)*($100/bbl.) = $120,000,000

The expected cost of production would be:

Expected cost = (1,200,000 bbl.)*($50/bbl.)= $60,000,000

The expected cash flows in one year would be:

Expected cash flow = Expected revenue - Expected cost - Cost of capital
= $120,000,000 - $60,000,000 - ($500,000,000*(1+0.1)) = -$158,000,000

Therefore, the NPV of postponing the project for one year would be:

NPV = -$158,000,000 / (1+0.1) = -$143,636,364

The NPV of the project if it were undertaken now is:

NPV = [($120/bbl.)*(1,200,000 bbl.)-($50/bbl.)*(1,200,000 bbl.)-($500 million)]/(1+0.1) = $116 million

The expected NPV of the project next year would be:

Expected NPV = [($120/bbl. - $50/bbl.)*(1,200,000 bbl.)-($500 million)]/(1+0.1) = $154 million

The difference between the expected NPV next year and the NPV if the project is postponed by one year is:

$154 million - (-$143,636,364) = $297,636,364

Therefore, the best choice is B, as postponing the project by one year would result in a lost value of $297,636,364.