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4. Abandonment Option (Two-Stage Binomial Tree) A large Canadian oil company is looking to invest in an oil field in Northern Alberta. The project requires a $700 million upfront investment, and is expected to generate cash flows worth $1,200 million in present value terms Management is closely watching a series of court rulings that will affect planned pipeline expansions within the next year. A favourable ruling should result in greater market access for Alberta's oil, which implies a higher oil price and hence higher profits for the project. The first ruling is scheduled for 3 months from now. There are two potential outcomes: If the ruling is positive, management expects to revise its estimate about the present value of the project's future cash flows upwards by a factor of 1.2 -i.e. the revised value estimate 3 months from now would be 1200 x 1.2 S1440 million. If the ruling is negative, management expects to revise its estimates about the present value of the project's future cash flows downwards by a factor of the revised value estimate 3 months from now would be 1200 1.2-$1000 million. 1.2 The second ruling is scheduled for 6 months from now. Regardless of whether the first ruling is positive or negative, a positive (negative) ruling for the second court decision should lead management to further revise its value estimate upwards (downwards) by the same factor of 1.2 (2). For example, an initial positive ruling followed by a subsequent negative ruling would result in a revised value estimate 6 months from now of 1200 1.2 : 1.2 $1200 million At any point in time between now and six months from now, the company can abandon the project and sell the assets of the oil field project for $1,100 million. (a) (1 point) What is the static NPV of the oil field project (not including the aban- donment option)? (b) (7 points) Given an annual risk-free rate of 4%, what is the NPV of the oil field project including the abandonment option using binomial option pricing? What is the value of the abandonment option? (c) (2 points) Suppose that the initial court decision in 3 month's time is negative Should the company look to abandon the project at that point? Why or why not? 4. Abandonment Option (Two-Stage Binomial Tree) A large Canadian oil company is looking to invest in an oil field in Northern Alberta. The project requires a $700 million upfront investment, and is expected to generate cash flows worth $1,200 million in present value terms Management is closely watching a series of court rulings that will affect planned pipeline expansions within the next year. A favourable ruling should result in greater market access for Alberta's oil, which implies a higher oil price and hence higher profits for the project. The first ruling is scheduled for 3 months from now. There are two potential outcomes: If the ruling is positive, management expects to revise its estimate about the present value of the project's future cash flows upwards by a factor of 1.2 -i.e. the revised value estimate 3 months from now would be 1200 x 1.2 S1440 million. If the ruling is negative, management expects to revise its estimates about the present value of the project's future cash flows downwards by a factor of the revised value estimate 3 months from now would be 1200 1.2-$1000 million. 1.2 The second ruling is scheduled for 6 months from now. Regardless of whether the first ruling is positive or negative, a positive (negative) ruling for the second court decision should lead management to further revise its value estimate upwards (downwards) by the same factor of 1.2 (2). For example, an initial positive ruling followed by a subsequent negative ruling would result in a revised value estimate 6 months from now of 1200 1.2 : 1.2 $1200 million At any point in time between now and six months from now, the company can abandon the project and sell the assets of the oil field project for $1,100 million. (a) (1 point) What is the static NPV of the oil field project (not including the aban- donment option)? (b) (7 points) Given an annual risk-free rate of 4%, what is the NPV of the oil field project including the abandonment option using binomial option pricing? What is the value of the abandonment option? (c) (2 points) Suppose that the initial court decision in 3 month's time is negative Should the company look to abandon the project at that point? Why or why not