Use the black-scholes model to estimate the value

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Reference no: EM131965513

The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that 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 there is a 10% chance that they would be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10%. Use the Black-Scholes model to estimate the value of the option.

Assume the variance of the project's rate of return is 6.32% and that the risk-free rate is 8%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.

Reference no: EM131965513

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