Oklahoma Oil started extracting oil from a well a few years ago. The project cost...
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Oklahoma Oil started extracting oil from a well a few years ago. The project cost $12.5 million and generated expected perpetual cash flows of $1.125 million per year. With WACC = 9%, the project was worth PV = 1.125/.09 = $12.5 million. Subtracting the investment of $12.5 million gave NPV = 0. Several years later, the projects expected cash flow started to weaken. Cash flows are still expected to be perpetual but are now running at only $450,000 a year. The project is now worth only $450,000/.09 = $5 million. Suppose the project can be abandoned, with recovery of $5.5 million from the sale of machinery and real estate. However, the company is questioning what if they wait and reconsider abandonment later? i.e., the company wants to value an abandonment option that does not have to be exercised immediately. Can this abandonment option be valued as a put or as a call option? Assume for simplicity that the option lasts one year only (abandon now or at year 1) and that the one-year standard deviation of the project is 30%. The risk-free interest rate is 4%. Value this option and advise whether the company should abandon the project immediately.
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