I. Company background and description on each of 4 projects
In 1991, Amoco Corporations, a conglomerate of petroleum and chemical corporations, decided to divest some of their smaller properties and when further cuts were needed, they looked to divest the middle section of assets in its marginal curve. As a result, they formed MW Petroleum, a free-standing exploration company that was even as large as some of independent oil companies. It operated exploration and development for well, approximately working interests in 9,500 wells in 300 production areas.
Amoco then prepared to sell MW Petroleum to a mid-size independent petroleum company. Apache Corporation was interested in buying most portions of MW and was the only buyer that appears to be a good fit in the market at that time. Apache, with revenue of $270 million, believed that achieving high profit could be realized by acquiring marginal properties and operating well with expertise. Therefore, the deal was likely to be a win-win situation for both parties, if they could reach a reasonable price to accept.
The asking price from Amoco was $1 billion. Was it a reasonable price?
We will discuss this number, and find a conclusion to this question through our document.
II. Valuation Methodology
Generally, the Discounted Cash Flow method is the most popular valuation methodology for financial analysts. It uses the concept of time value of money; the future cash flows are estimated and discounted back to present value with the discount rate which is the cost of capital incorporated with the risk of the project. However, questions still arise if the DCF is the right valuation tool for every project evaluations, regardless of features embedded in the projects. DCF is used to evaluate the projects at initial by assuming all the expected cash flows are likely to be generated; however, it does not incorporate management’s ability to make changes or react to situation along the way. Opportunities for R&D, M&A, licensing, expanding, downsizing, and abandoning projects are the examples of flexibility that managers can potentially execute but DCF does not capture the value. In the end, rejecting projects with negative NPV might actually disregard investments that offer a company more flexibility in operations and investing.
Real option valuation is more appropriate in evaluating investments under conditions of uncertainty that is the successfulness of the reserves in this case (proved developed, proved undeveloped, probable and possible reserves). It captures the value of the options embedded in each investment projects. There are 4 approaches of option pricing: Black-Scholes formula, replicating-portfolio approach, expectation pricing, and risk neutral valuation. In this case, we used Black-Scholes formula.
III. The solution for this case uses several assumptions for each variable
Duration:
Duration use in this solution based on time that the company spent high capital expenditure. The assumption is that the high capital expenditure is used for investment. The investment goal is to maintain developed proven reserve and to develop the undeveloped proven reserve, probable reserve and possible reserves.
In this case:
Duration for proved developed reserve is three years because the high capital expenditure spends are in year 1, 2, and 3. After three years the capital expenditure is low therefore should be treated as production cost rather than investment.
Duration for proved undeveloped reserves is four years because the high capital expenditure spends are in year 1, 2, 3, and 4. After four years the capital expenditures is low therefore should be treated as production cost.
Duration for probable reserves is five years because the high capital expenditure spends are in year 1, 2, 3, 4, and 5. After five years the capital expenditures is low therefore should be treated as production cost.
Duration for possible reserves is six years because the high capital expenditure spends are in year 1, 2, 3, 4, 5 and 6. After six years the capital expenditures is low therefore should be treated as production cost.
Cash in:
Cash in use in this case is divided into two parts. First part, cash in within duration time. Cash in during that time is cash that generate from operation. In the second part, cash in after duration time. Cash in that use is cash that generate from operation and terminal time subtract with capital expenditure. Detail of the cash in could be seeing in the Appendix.
Cash out:
Cash out use in this case is the cash use for investment. The team assumes the cash use for investment is the highest capital expenditures spend by the company. Detail of the cash in could be seeing in the table Appendix.
Volatility:
The team assumes the volatility of the project base on the probability of the reserves for going production as predicted. That probability could be seen in the table below which is based on oil and gas term, source of investopedia.com.
Oil & Gas Reserve Clasification | Probability for having reserves or going to production as predicted |
Proved | 90% |
Probable | 50% |
Possible | 10% |
Table 1.
Risk free rate:
Risk free rate use is 10 years U.S. government bond in 1990 and 1991 which is 2.67
Risk free rate use is 10 years U.S. government bond in 1990 and 1991 which is 2.67
IV. Calculation
Price for the four projects is the total premium of real option of the four projects. Detail calculation of the projects is shown below.
a. Proved Developed Reserve
Interest risk free: 2.66%
NPV cash in (Ps): $671.47
NPV cash out (Pe): $9.65
Duration: 3 years
Volatility: 90%
b. Proved Undeveloped Reserve
Interest risk free: 2.66%
NPV cash in (Ps): $185.14
NPV cash out (Pe): $45.50
Duration: 5 years
Volatility: 90%
c. Probable Reserve
Interest risk free: 2.66%
NPV cash in (Ps): $156.85
NPV cash out (Pe): $39.24
Duration: 5 years
Volatility: 50%
d. Probable Reserve
Interest risk free: 2.66%
NPV cash in (Ps): $204.75
NPV cash out (Pe): $104.31
Duration: 6 years
Volatility: 10%
The total price we could give is equal to $ 1,072.12 Millions (662.56 Millions + 157.89 millions + 129.17 millions + 122.50 millions).
V. Conclusion
With the calculation we can conclude that the asked price from Amoco of 1 billions is lower than real option exercise. Therefore by exercise we can get economic profit of $ 72.12 millions (1,072.12 millions – 1,000 millions).
Therefore Apache should exercise the asked price from Amoco to gain the economic profit.
Reference
3. MW Petroleum Case, Harvard Business Review Case.
May I see your appendices for MW Corporation?
BalasHapus