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 7%. 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
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 7%. 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
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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12.
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 7%. 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
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