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.

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