Determine what is the projects net present value

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Reference no: EM13327278

The Karns 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 the 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, it 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. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?

c. Assume the risk free rate is 6% and the variance of the project's rate of return is 1.11 percent. Use the Black-Scholes model to estimate the value of the option

Reference no: EM13327278

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