The Duluth Oil Company is deciding whether to drill for oil on a tract of land the company owns. The company estimates the project would cost $5 million today. Duluth estimates that, once drilled, the oil will generate positive net cash flows of $2 million a year at the end of each of the next 5 years. Although the company is fairly confident about its cash flow forecast, in a year it will have more information about the local geology and about the price of oil. Duluth estimates that if it waits for 1 year then the project would cost $5.5 million. Moreover, if it waits 1 year, then there is a 80% chance that the net cash flows would be $2.5 million a year for 5 years and a 20% chance that they would be $1.2 million a year for 54 years. Assume all cash flows are discounted at 10%.
a. If the company chooses to drill today, what is the projects net present value?
b. Using decision-tree analysis, does it make sense to wait a year before deciding whether to drill? c. Using the Black-Scholes model to estimate the value of the real option. Assume that the variance of the projects rate of return is 0.111 and that the risk-free rate is 5%