Investment Timing Option: Option Analysis The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $9 million. Moreover, if it waits 2 years, 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 are discounted at 10%. Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 0.111 and that the risk-free rate is 6%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places. $ million
Investment Timing Option: Option Analysis The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $9 million. Moreover, if it waits 2 years, 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 are discounted at 10%. Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 0.111 and that the risk-free rate is 6%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places. $ million
College Physics
1st Edition
ISBN:9781938168000
Author:Paul Peter Urone, Roger Hinrichs
Publisher:Paul Peter Urone, Roger Hinrichs
Chapter34: Frontiers Of Physics
Section: Chapter Questions
Problem 22CQ: Must a complex system be adaptive to be of interest in the field of complexity? Give an example to...
Related questions
Question

Transcribed Image Text:Investment Timing Option: Option Analysis
The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will
generate positive net cash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the
local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $9 million. Moreover, if it waits 2 years, 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 are discounted at 10%. Use the Black-Scholes model to estimate the value of the
option. Assume the variance of the project's rate of return is 0.111 and that the risk-free rate is 6%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234
million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places.
$
million
Expert Solution

This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
Step by step
Solved in 2 steps

Recommended textbooks for you

College Physics
Physics
ISBN:
9781938168000
Author:
Paul Peter Urone, Roger Hinrichs
Publisher:
OpenStax College

Glencoe Physics: Principles and Problems, Student…
Physics
ISBN:
9780078807213
Author:
Paul W. Zitzewitz
Publisher:
Glencoe/McGraw-Hill


College Physics
Physics
ISBN:
9781938168000
Author:
Paul Peter Urone, Roger Hinrichs
Publisher:
OpenStax College

Glencoe Physics: Principles and Problems, Student…
Physics
ISBN:
9780078807213
Author:
Paul W. Zitzewitz
Publisher:
Glencoe/McGraw-Hill


College Physics
Physics
ISBN:
9781285737027
Author:
Raymond A. Serway, Chris Vuille
Publisher:
Cengage Learning

Physics for Scientists and Engineers with Modern …
Physics
ISBN:
9781337553292
Author:
Raymond A. Serway, John W. Jewett
Publisher:
Cengage Learning

Principles of Physics: A Calculus-Based Text
Physics
ISBN:
9781133104261
Author:
Raymond A. Serway, John W. Jewett
Publisher:
Cengage Learning