3- The Tamara 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 $7 million today. Tamara estimates that once drilled, the oil will generate positive net cash flows of $3 million a year at the end of each of the next 4 years. While the company if 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. Tamara estimates that if it waits 2 years, the project will cost $8 million. Moreover, if it waits 2 years, there is a 90% chance that the net cash flows will be $4million a year for 4 years, and there is a 10% chance that the cash flows will be $2million a year for 4 years. Assume that cash flows are discounted at 10%/
a- If the company chooses to drill today, what is the project’s NPV?
b- Would it make more sense to wait 2 years before deciding whether to drill? Explain.
c- What is the value of the investment timing option?
d- What disadvantages might arise from delaying a project such as this drilling project?
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