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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 $8 million today. Karns estimates that, once drilled, the oil
will generate positive 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 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 project's net present value?
b. Use the Black-Scholes 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 risk-free
rate is 6%.
c. Should Karns implement the project today or should it wait 2 years?
C=P**N(d1)-xe-rfTT**N(d2)
d1=ln(Px)+(rf+22)(T)22T2
d2=d1-22T2
Check answers:
a.4.68
b.P=10.48,2=0.0111,d1=1.90,d2=1.75,C=2.52
The answers must match exactly. And please show handwritten math in how to achieve the correct answers.
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