None The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The companyestimates the project would cost $8 million today. Karns estimates that, once drilled, the oil will generate positive netcash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about itscash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karnsestimates 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 a 10% chance that they would be $2.2 milliona year for 4 years. Assume all cash flows are discounted at 10%. Use the Black - Scholes model to estimate the value ofthe option. Assume the variance of the project's rate of return is 0.512 and that the risk - free rate is 6%. Do not roundintermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as1.234, not 1,234,000. Round your answer to three decimal places. $ million

Part 2: Explanation:Step 1: Calculate the present value (PV) of the cash flows if the project is…

Answered: The Karns Oil Company is deciding…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter14: Capital Structure Management In Practice

Section14.A: Breakeven Analysis

Problem 8P

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