Suppose that the oil price is uncertain and can be $60/bbl.or $30/bbl.next year with equal probability.Then the value of the option to postpone the project by one year equals:
A)+34 million
B)+25 million
C)+59 million
D)-13 million

Question

Quizplus · Accepted Answer

To calculate the option value, we need to compare the cash flow of the project with and without postponing it. 
If the project is executed this year, the cash flow will be:
$80 million - $60 million = $20 million
If the project is postponed by one year, the cash flow will be:
$100 million - option value
The option value can be calculated as the expected value of the project next year minus the value of the project next year if the option is not exercised (i.e., $80 million).
So, the expected cash flow of the project next year is:
(0.5 x $100 million) + (0.5 x $80 million) = $90 million
Therefore, the option value is:
$90 million - $80 million = $10 million
Subtracting this from the initial cash flow of $80 million, we get:
$80 million - $10 million = $70 million
So, if the project is postponed, the cash flow will be $70 million.
Therefore, the value of the option to postpone the project by one year is:
$70 million - $20 million = $50 million
which is closest to choice letter A.

Suppose That the Oil Price Is Uncertain and Can Be