Description

Case Notes on MW Petroleum Corporation (A)

Why Should We Care About Real Options?

Ignoring real options in a project often leads to an underestimation of the true project value. Because real options are not explicitly linked to cash flows, they may seem difficult to identify. Here are some typical examples of real options.

• The option to expand an existing investment project.
• Research and development (R&D) is an example of a growth option.
• The option to delay an investment project.
• The option to abandon a project that has already been undertaken.

From the above examples, we find that real options reflect the flexibility inherent in any capital investment process, which is often ignored by the DCF analysis because flexibility is hard to quantify in terms of cash flows. Fortunately, the breakthrough in option pricing theory provides us with the tools to find the value of these real options.

Types of Reserves

MW Petroleum’s estimated reserves can be classified into four major categories:

• proved developed reserves
• proved undeveloped reserves
• probable reserves
• possible reserves

Exhibits 3-6 tell us the production and cash flow projections for each of the four types of reserves.

Risk-adjusted Discount Rate (RADR)

For valuation purposes, we need an estimate of MW's WACC to discount cash flows. Unfortunately, the case does not provide many details. This presents a very realistic problem that is often faced when attempting to do analysis in the real world. For example, because MW is a subsidiary of Amoco, its (market) equity value is not available. We do not have a clear idea about the debt and equity mix of MW either. However, we do have the following information:

The average asset (unlevered) beta for Oil companies = 0.64 (footnote b of Exhibit 2).

Given this information, we can use the CAPM to calculate the cost of equity for MW.

• Cost of equity = risk-free rate + beta * market risk premium

For the risk-free rate, we can use the 1990 year-end 30-year US government bond yield given in the MW case in Exhibit 10. We choose the 30-year bond because the time horizon of the cash flows given in the case is 15 years (US government bonds are available in 10-year and 30-year maturities, but none in-between). Remember, projects in this industry are long-term and, therefore, call for a longer-term Treasury yield to proxy for the risk-free rate.

To determine the market risk premium, we can rely on a report that is maintained by the Stern School of Business at New York University. This report maintains historic annual returns on stock, T-bonds, and T-bills from 1928 – Current. The report also maintains the historical market-risk premium (MRP), starting in 1960. To be consistent with our risk-free rate, we want to use the historical market-risk premium for 1990 in the following report:

• http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
• In order to get the MRP, you must click on the link at the top of this page and download the Excel spreadsheet. The historical MRPs are located on the Returns by year tab.

Next, we assume that Miller Equilibrium holds. This implies:

• The WACC, which is the risk-adjusted discount rate for discounting free cash flows, is the sum of the after-corporate-tax yield on taxable risk-free debt and a risk premium.
• The risk premium is the product of the asset beta (relative to the market portfolio of equity securities) and the market risk premium.
• The market risk premium is measured relative to the after-corporate-tax yield on taxable risk-free debt.

If taxes are zero, the WACC is independent of capital structure. Therefore, WACC = cost of equity.

Identifying the Real Options

Your first task is to identify the real options associated with these reserves. The fundamental characteristic of an option is that the option-holder has the RIGHT but not the obligation to do something (such as buy a stock or invest in a project). Clearly, the proved developed reserves of MW are assets-in-place rather than options. One way to verify this is to look at the capital expenditure in Exhibit 3, which is relatively small even in the early years compared with the cash from operations.

On the other hand, for proved but undeveloped reserves, the capital expenditure (shown in Exhibit 4) in the first two years are much larger than the cash from operations, which suggests that the proved undeveloped reserves should be treated as real options, as these large capital expenditures represent the investment needed to begin this project (i.e., the strike price on the real option). In addition, on the fourth page of this case, the case writer states that “MW could leave these (proved but undeveloped) reserves undeveloped while retaining the RIGHT to develop them later.” This clearly indicates that the proved undeveloped reserves should be valued using the option approach. Therefore, the following discussion will focus on MW’s proved undeveloped reserves and you will extend the analysis to the remaining types of reserves that represent real options.