Question

Capital budgeting with real options. XYZ ompany is evaluating the feasibility of pumping oil in a newly discovered oil well in Lake YYY. The company estimates that today the investment in the project would amount to 75 million euros. The company estimates that the positive cash flow after the construction of the drilling tower will be EUR 36 million per year over the next four years. Although the company is quite confident in its forecasts, in two years time it would be possible to say more precisely, what the actual impact of this project will be on the local environment and the quality and price of the oil being pumped. Therefore, the company could postpone the investments for two years. The company predicts that investment in the project (if postponed) is expected to increase to EUR 90 million in two years; time. There is an 80% probability that the annual positive cash flow is going to be EUR 50 million and with a 20% probability the cash flow could be as low as EUR 24 million a year for every subsequent four years. It would be known in two years what scenario will start. The XYZ Company has also entered into negotiations with Rosneft, which suggests that drilling rights for oil pumping may be sold to ZZZ in after two years for EUR 10 million. Of course, if you sell drilling rights, you can no longer drill yourself. The cost of capital is 10%

Question:
c) Does this project includes any applications of real options? Explain.

Answer 1

In this case firstly there is the postponement option available to the firm. In such a scenario the revenues and expenses will differ if the investment is postponed by 2 years. The other option available is to drill yourself or to sell the rights of drilling. Hence real options are available to the firm which must be considered. These are choices available to the managers of the firm.