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Question - Luckoil Inc. owns a lease to extract crude oil from sea for 10 years starting immediately. It is considering the construction of a deep-sea oil rig at a cost of $47 million which is expected to remain constant. The extraction costs are $35/bbl. The quantity of oil Q = 300,000 bbl per year forever. The cost of capital is 6% per year (ignore taxes).
Next year when the rig is constructed the price is expected to be either $60/bbl or $40/bbl (and is expected to remain constant) with 70% and 30% probability, respectively. The firm can open the rig in one year when it knows price for sure. If the firm chooses to wait, it will have to cover fixed costs, $1 million, during the idle year.
Calculate NPV of the project if Luckoil opens the rig immediately.
Describe the tradeoff the firms faces while considering whether to open the rig immediately or wait until the price is known.
Calculate NPV with the option to wait.
Calculate value of the option to wait.
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