You’ve struck oil in Texas! However, the terrain is tricky

You’ve struck oil in Texas! However, the terrain is tricky and the upfront cost (immediate cost) of extracting with current technology is $38 million. You’ve also heard of a new extraction technology being developed at UGA. There is an 80% chance that this technology will be successful and ready to use in exactly one year. If it’s not ready in one year (20% chance), then it will never be ready. The new technology is expected to reduce the extraction cost to $16 million. If you decide to wait, you will have to pay $5 million to the landowner as a fee to prevent other oil companies from trying to drill on the land. This payment would be due at the end of the year. You also know the following:

  • 1. You can extract 100,000 barrels every year forever once you pay the upfront extraction cost
  • 2. The price of a barrel of oil is expected to be $50 at the end of this year and is expected to fall by 4% every year forever. All revenues are realized at the end of the year.
  • 3. There are no extraction costs other than the upfront cost
  • 4. Your opportunity cost of capital is 10%Q

-What is the NPV of the project if you decide to drill today?

-What is the NPV of the project if you decide to wait one year?

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