Problem 1: G.D. Sorrell is developing an anticancer drug. The project is in its preliminary stage. G.D.S. must decide whether to initiate a large-scale drug test costing $1.5 million a year for two years. If the test results are positive, a $17.5 million plant to produce the drug for commercial trials will be built at the end of the testing period. If commercial sales of the drug meet the company's forecast for the next two years, a second, larger plant costing $50 million will be built to produce the drug in quantity. The cash flows resulting from this larger plant are expected to be $76 million for eight years after it is built.The following are the relevant cash flows associated with the three possible scenarios.
|
|
Year 0
|
1
|
2
|
3
|
4
|
5-12
|
|
Scenario 1
|
($ 1,500)
|
($ 1,500)
|
Unsuccessful
|
|
$2,000
|
|
|
Scenario 2
|
(1,500)
|
(1,500)
|
(17,500)
|
$3,000
|
7,500
|
Unsuccessful
|
|
Scenario 3
|
(1,500)
|
(1,500)
|
(17,500)
|
5,000
|
(50,000)
|
9,500
|
|
|
|
|
|
|
(50,000)
|
|
a. With a cost of capital of 10%, value the research project using DCF analysis. Is the project acceptable? (Assume the two plants are built.)
b. Assuming that the three possible scenarios have equal probability, is the project accept- I able? (Hint: Value this project as a growth option.)
Problem 2: An oil company has paid $100,000 for the right to pump oil on a plot of land during the next three years. A well has already been sunk and all other necessary facilities are in place. The land has known reserves of 60,000 barrels, The company wishes to know the market value of this operation. The interest rate is 8% and the marginal cost of pumping is $8 per banel. Both these costs are expected to remain unchanged over the three-year period.The current price of oil is $10 per barrel. Company economists have estimated the following:
(1) Oil will increase in price by 10% with a probability of 40%, or decrease in price by 12% with a probability of 60% during each of the next three years.
(2) The cost of storing oil in above-ground tanks is $0.50 per year.
(3) The company can pump a maximum of 20,000 barrels per year at the site.
(4) The site may be shut down for a year and then reopened at a cost of $2,000.
Determine the market value of the operation ignoring taxes. Assume that all cash flows occur at the end of each year. (Hint: Chart all possible sequences of oil prices, and calculate the optimal production decisions and payoffs associated with each sequence.)