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Essentials Of Investments
11th Edition
ISBN: 9781260013924
Author: Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher: Mcgraw-hill Education,
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Investment Timing Option: Decision-Tree Analysis
The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million
today. Kams 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 oill. Karms
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 a 10% chance that they would be $2.2 million a year for 4 years. Assume all cash flows are discounted at 8%.
a. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For
example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places.
million
$
b. Using decision-tree analysis, does it make sense to walt 2 years before deciding whether to drill?
-Select-
Check My Work (5 remaining)"
Transcribed Image Text:eBook
Video
Investment Timing Option: Decision-Tree Analysis
The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $8 million
today. Kams 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 oill. Karms
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 a 10% chance that they would be $2.2 million a year for 4 years. Assume all cash flows are discounted at 8%.
a. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For
example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places.
million
$
b. Using decision-tree analysis, does it make sense to walt 2 years before deciding whether to drill?
-Select-
Check My Work (5 remaining)
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