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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
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 $ million today. Karns estimates that, once drilled, the oil
will generate positive cash flows of $ million a year at the end of each of the next years. Although the
company is fairly confident about its cash flow forecast, in years it will have more information about
the local geology and about the price of oil. Karns estimates if it waits years then the project would
cost $ million. Moreover, if it waits years, then there is a chance that the net cash flows would
be $ million a year for years and a chance that they would be $ million a year for years.
Assume all cash flows are discounted at
a If the company chooses to drill today, what is the project's net present value?
b Use the BlackScholes model to estimate the value of the investment timing option. Use the
indirect approach to calculate the project's variance of the rate of return. Assume the riskfree
rate is
c Should Karns implement the project today or should it wait years?
Check answers:
a
b
The answers must match exactly. And please show handwritten math in how to achieve the correct answers.
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