Investment Timing Option: Option Analysis The Karns Oil Company is deciding whether to drill for oil on a tract of land
Posted: Wed Jul 06, 2022 6:43 pm
Investment Timing Option: Option Analysis
The Karns Oil Company is deciding whether to drill for oil on atract of land that the company owns. The company estimates theproject would cost $8 million today. Karns estimates that, oncedrilled, the oil will generate positive net cash flows of $4million a year at the end of each of the next 4 years. Although thecompany is fairly confident about its cash flow forecast, in 2years it will have more information about the local geology andabout the price of oil. Karns estimates that if it waits 2 yearsthen the project would cost $9 million. Moreover, if it waits 2years, then there is a 90% chance that the net cash flows would be$4.2 million a year for 4 years and a 10% chance that they would be$2.2 million a year for 4 years. Assume all cash flows arediscounted at 10%. Use the Black-Scholes model to estimate thevalue of the option. Assume the variance of the project's rate ofreturn is 0.512 and that the risk-free rate is 5%. Do not roundintermediate calculations. Enter your answer in millions. Forexample, an answer of $1.234 million should be entered as 1.234,not 1,234,000. Round your answer to three decimal places.
The Karns Oil Company is deciding whether to drill for oil on atract of land that the company owns. The company estimates theproject would cost $8 million today. Karns estimates that, oncedrilled, the oil will generate positive net cash flows of $4million a year at the end of each of the next 4 years. Although thecompany is fairly confident about its cash flow forecast, in 2years it will have more information about the local geology andabout the price of oil. Karns estimates that if it waits 2 yearsthen the project would cost $9 million. Moreover, if it waits 2years, then there is a 90% chance that the net cash flows would be$4.2 million a year for 4 years and a 10% chance that they would be$2.2 million a year for 4 years. Assume all cash flows arediscounted at 10%. Use the Black-Scholes model to estimate thevalue of the option. Assume the variance of the project's rate ofreturn is 0.512 and that the risk-free rate is 5%. Do not roundintermediate calculations. Enter your answer in millions. Forexample, an answer of $1.234 million should be entered as 1.234,not 1,234,000. Round your answer to three decimal places.