The Karns Oil Company is deciding whether to drill for oil on a tract of land 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%.

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 2 years before deciding whether to drill? (discount everything at cost of capital)

c. Using the Black-Scholes model to estimate the value of the option. Assume that the variance of the projects rate of return is 0.111 and that the risk-free rate is 6%.