If the land has already been purchased should drilling begin immediately If

If the land has already been purchased should

  • University Canada West
  • UCW 002
  • Notes
  • sarahadams1409
  • 43
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. If the land has already been purchased, should drilling begin immediately? If drilling begins immediately, the NPV is –$110,000: If the drilling decision is delayed until new information is released in a year, the optimal choice can be made at that time. If oil prices drop to $35 a barrel, Exoff should not drill. Instead, the firm should walk away from the project, losing nothing beyond its $10,000 purchase price for the land. If oil prices rise to $65, drilling should begin. Mr. Thornton points out that by delaying, the firm will invest the $500,000 of drilling costs only if oil prices rise. Thus, by delaying, the firm saves $500,000 in the case where oil prices drop. Kirtley concludes that once the land is purchased, the drilling decision should be delayed. 9 The first two effects support delaying the decision. The third effect supports immediate drilling. In this example, the first effect greatly outweighs the other two effects. Thus, Mr. Thornton avoided the second and third effects in his presentation. We now know that if the land has been purchased, it is optimal to defer the drilling decision until the release of information. Given that we know this optimal decision concerning drilling, should the land be purchased in the first place? Without knowing the exact probability that oil prices will rise, Mr. Thornton is nevertheless confident that the land
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should be purchased. The NPV of the project at $65 per barrel oil prices is $1,390,000, whereas the cost of the land is only $10,000. Mr. Thornton believes that an oil price rise is possible, though by no means probable. Even so, he argues that the high potential return is clearly worth the risk. This example presents an approach that is similar to our decision tree analysis of the Solar Equipment Company in a previous chapter. Our purpose in this section is to discuss this type of decision in an option framework. When Exoff purchases the land, it is actually purchasing a call option. That is, once the land has been purchased, the firm has an option to buy an active oil field at an exercise price of $500,000. As it turns out, one should generally not exercise a call option immediately. 10 In this case the firm should delay exercise until relevant information concerning future oil prices is released. The firm would receive cash flows from oil earlier if drilling begins immediately. This is equivalent to the benefit from exercising a call on a stock prematurely in order to capture the dividend. However, in our example, this dividend effect is far outweighed by the benefits from waiting. This section points out a serious deficiency in classical capital budgeting: Net present value calculations typically ignore the flexibility that real-world firms have. In our example the standard techniques generated a negative NPV for the land purchase. Yet by allowing the firm the option to change its investment policy according to new information, the land purchase can easily be justified.
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