In less than five, double-spaced, typewritten pages, plus any exhibits, In less than five, double-spaced, typewritten pages, plus any exhibits, please answer the following questions about MW
please answer the following questions about MW Petroleum Corp !hisPetroleum Corp !his assignment is worth a maximum of "## points " $"# points% &part assignment is worth a maximum of "## points " $"# points% &part from any quantitative analysis, are there any reasons to anticipate that from any quantitative analysis, are there any reasons to anticipate that &pache Corporat
&pache Corporation's acquisition of MW Petroleum might be a ion's acquisition of MW Petroleum might be a positivepositive net present value activity for &pache, for &moco( )xplain !his loo*s net present value activity for &pache, for &moco( )xplain !his loo*s li*e an attractive deal for both parties &moco does many things well, li*e an attractive deal for both parties &moco does many things well, bu
but t mamananagiging ng smsmalallelerr, , mamargrgininalally ly prprododucuctitive ve oioil l anand d gagas s fifieleldsds ap
appaparerentntly ly isisn't n't onone e of of ththemem !h!his is is is a a chchanance ce to to ununloload ad sosomeme pro
propepertirties es ththat at becausbecause e of of thetheir ir highigh h coscost t strstructureucture, , &m&moco oco cancan't't manage profitably &pache, on the other hand, has low costs and is an manage profitably &pache, on the other hand, has low costs and is an efficient operator of small- to mediumsi+ed properties !he company efficient operator of small- to mediumsi+ed properties !he company ha
has s grgrowown n sisigngnificificanantltly y in in rerececent nt yeyearars s by by acacququiririning g leless ss wewellllrurunn properties and applying its rationali+e and reconfigure strategy !he properties and applying its rationali+e and reconfigure strategy !he MW Petroleum properties appear to offer the opportunity to continue MW Petroleum properties appear to offer the opportunity to continue this strategy If &moco can stri*e a price wherein &pache shares some this strategy If &moco can stri*e a price wherein &pache shares some of its
of its operating savings with &mocooperating savings with &moco, both , both parties can generate positiveparties can generate positive net present values from the transaction &cquisition of MW Petroleum net present values from the transaction &cquisition of MW Petroleum may also reduce the volatility of &pache's cash flows by ma*ing them may also reduce the volatility of &pache's cash flows by ma*ing them less dependent on gas <hough this may not benefit shareholders less dependent on gas <hough this may not benefit shareholders directly, it will li*ely enable management to sleep better and might directly, it will li*ely enable management to sleep better and might increase &pache'
increase &pache's s borrowing capacity, thereby benefiting borrowing capacity, thereby benefiting shareholdshareholdersers in
indidirerectctlyly . . $"$"# # popoinintsts% % WhWhosose e prpro/o/ecectitionons s apappepear ar in in ththe e cacasese exhibits( 0rom &pache's perspective, is there any reason to believe exhibits( 0rom &pache's perspective, is there any reason to believe these numbers might be biased one way or another( 1oes the value of these numbers might be biased one way or another( 1oes the value of MW
MW PePetrtrololeueum m dedeririveved d frfrom om ththesese e nunumbmberers s rereprpresesenent t &&papachche'e'ss maximum acquisition price( )xplain !he story appears to be a mixed maximum acquisition price( )xplain !he story appears to be a mixed on
one e &<lthohougugh h &&papachche e is is cacapapablble e of of mama*i*ing ng itits s owown n cacash sh flflowow pro/ections, the pro/ections presented are not &pache's In particular, pro/ections, the pro/ections presented are not &pache's In particular, the
the oil oil anand d gagas s priprice ce forforecaecasts sts wewere re comcompilpiled ed by by MorMorgan gan 2ta2tanlenleyy $re
$reprepresensentinting g &m&moco oco in in ththe e sasale%le% !h!he e estestimaimates tes of of resreserverves es andand annual production figures were generated by independent petroleum annual production figures were generated by independent petroleum engineers $presumably paid by &moco% !he forecasts of direct costs engineers $presumably paid by &moco% !he forecasts of direct costs are based primarily on &moco's historical experience, and pro/ected are based primarily on &moco's historical experience, and pro/ected ov
overerhehead ad is is babasesed d on on amamouountnts s &m&mococo o ititseself lf exexpepectcts s to to sasave ve byby div
divesestinting g MWMW 3ec3ecallall, , ththe e basbasic ic premispremise e of of the the tratransansactiction on is is ththatat &pache
such efficiencies have not yet been incorporated into the pro/ections, such efficiencies have not yet been incorporated into the pro/ections, there is reason to believe the direct costs are overstated from &pache's there is reason to believe the direct costs are overstated from &pache's pe
persprspectectiveive 5o5oo*io*ing ng ononly ly at at the the dirdirect ect cocostssts, , thetheir ir oveoverstrstateatemenmentt suggests that the resulting valuation may be biased low If so, the suggests that the resulting valuation may be biased low If so, the val
valuauatiotion n wilwill l be be belbelow ow &&pacpachehe's 's maxmaximuimum m acqacquisuisitiition on pripricece, , anandd &pache
&pache could could bid bid above above this this figure figure and and still still generate generate a a positive positive 6P76P7 !he valuation might be viewed more properly as &moco's reservation !he valuation might be viewed more properly as &moco's reservation price, below which it should not sell 8 $.#
price, below which it should not sell 8 $.# points% )xhibits 8-9 containpoints% )xhibits 8-9 contain cas
cash h floflow w prpro/eo/ections ctions for for MW MW PetPetrolroleumeum !!o o whwhat at extextent ent do do thethesese numbers represent free cash flows suitable for use in a discounted numbers represent free cash flows suitable for use in a discounted cash flow valuation( In particular, please comment on the treatment of cash flow valuation( In particular, please comment on the treatment of overhead $line :%, financial
boo* 11;& $line <%, taxes $lines ""-"=%, 6on-cash charges $line ">%, and terminal value $line .#% <hough one might quibble with some details, I find the exhibits properly represent the free cash flows suitable for use in a discounted cash flow analysis !his is not to say the numbers are necessarily accurate, only that they are manipulated properly in the exhibits ?verhead &s discussed in the 1iamond Chemical case, overhead does not mean fixed 7ariable overhead is relevant to valuing MW, fixed overhead isn't &bsent information to the contrary, it seems appropriate to consider these costs variable !his is a little tric*y !he exhibits calculate profit contribution based on financial boo* reporting numbers !hey subtract financial boo* 11;& to calculate net income before taxes, and then they subtract total income taxes $or more commonly, provision for taxes% to calculate profit contribution $or more commonly, net income after taxes% 0inally, the exhibits determine cash flow from operations by adding bac* financial boo* accounting and deferred taxes, both of which are non-cash charges !he resulting cash flow from operations is correct !his is made more confusing by the fact that, contrary to most investment opportunities, deferred taxes are negative every year, ma*ing current taxes paid higher than provision for taxes !his also means that the adding bac* of deferred taxes actually reduces cash flow from operations 6ote, too, there is a little circularity going on here because the value of MW and the level of 11;& expenses depend on one another !he authors of the exhibits have sidestepped this problem by basing depreciation on a ballpar* number for the value of the business With more information about the depreciation methods employed, we could eliminate this circularity @ere, we must accept the $probably modest% error involved !axes &s /ust noted the correct tax figure is current tax, and the exhibits arrive at this figure by first subtracting total income taxes, and then adding deferred taxes bac* !his is part of the same 11;& A taxes story &nd in con/unction with the treatment of these other items, the treatment of 6on-cash charges is correct & terminal value estimate is clearly necessary &nd with a wasting asset, the approach ta*en appears appropriate We might as* if the terminal value includes estimated values of remaining assets, including land, when the reserves expire We might also as* why a "8B discount rate was applied without explanation or /ustification My calculations below
suggest this discount rate might be a bit on the high side, but not far from the mar*
0inancial boo* 11;& 6on-cash charges !erminal value
= $"# points% Page of the case contains the following statement, @ence, production and cash flow forecasts for probable reserves often had to be ris*-weighted based on available data and historical experience in comparable fields, to arrive at an estimate that reflected their expected value What do you thin* it means to ris*-weight cash flows( @ere's my interpretation !he correct free cash flow to use in discounted cash flow valuation is the annual expected free cash flow When the annual distribution of free cash flows is symmetric, the expected free cash flow equals the most li*ely free cash flow &bsent a symmetric distribution, this is no longer true and it becomes necessary to weight the outcomes by their probability of occurrence to calculate the expected value !he cash flows from the less certain reserves are li*ely to be asymmetric because there is a meaningful chance that future energy prices will ma*e it uneconomic to exploit the reserves @ere's an example !here are three possible outcomesD E"##, E#, and -E# with probabilities of .#B, #B, and 8#B, respectively !he most li*ely outcome is E#, but the expected outcome is E8# $.xE"## F x E# F 8x-E#% !he correct number for valuation purposes is E8# $8# points% &ssuming &pache will borrow up to the #B ceiling mentioned on page 9 of the case to finance any acquisition of MW Petroleum, execute a discounted cash flow valuation of all of the MW reserves described in )xhibits 8-9 $Please assume the #B ceiling applies to proved developed reserves% !he easiest way to value MW Petroleum is via &d/usted Present 7alue &s always, a W&CC valuation or an equity valuation are theoretically possible, but quite difficult to apply !o implement a W&CC valuation, we need to estimate &pache's W&CC at its postacquisition capital structure !his is difficult because we need to *now the post-acquisition mar*et value of &pache's equity, which presumes we *now the mar*et value of MW Petroleum A the precise value we see* to estimate in the first place We can get around this by solving for the W&CC and the mar*et value of MW Petroleum simultaneously, but this is not easy & second problem is that because MW Petroleum consists of wasting assets, the amount of debt it can support each year in the future will decline, meaning that a different capital structure and a different W&CC exists each year in the future &gain, we can handle this problem mathematically, but it isn't easy
rate if we believe MW's assets are safer or ris*ier than &pache's existing assets &n equity valuation faces the same problems on steroids because the cost of equity capital is much more sensitive to changes in capital structure than the W&CC is Moreover, because we ultimately want the enterprise value of MW, not the equity value, estimating the equity value needlessly complicates the valuation !o implement an &P7 valuation, we need to do two things 0irst, estimate the all-equity value of MW by discounting the free cash flows in )xhibit 9 by a suitable all-equity cost of capital &nd second, estimate the present value of the interest tax shields associated with use of debt to finance the company 2tep two involves estimating MW's debt capacity, deciding how this capacity changes over time, and finding the present value of the resulting interest tax shields at an appropriate discount rate !he value of MW is the sum of its all equity value and the present value of the interest tax shields
&ll-equity cost of capital Gsing the C&PM, He ig FJ 3p, where He is the all-equity cost of capital, ig is a ris*free interest rate, J is MW's asset beta, or its unlevered beta, and 3p is a mar*et ris* premium 4ecause this is a "-year asset, I chose to use the "#-year !reasury rate of :#8B !he 8#year rate of :.=B is also plausible, as is the 8#-day rate of >.B -- although my strong preference is for one of the longer-term rates given that we are valuing a long-term asset )xhibit . provides &pache's asset beta and the mean asset beta of six independent energy companies including &pache I prefer the mean asset beta because I want an industry beta, not &pache's, and because I *now for statistical reasons that the average of several observations should a more accurate estimate of the industry beta than a single observation !he mean beta is #>= $!his might appear low but remember that beta captures systematic ris*, and much of the ris* in energy companies is unsystematic% My preference for 3p is the historical arithmetic excess return on common stoc*s relative to government bonds, or about 9B &n historical geometric excess return of about percent is also defensible $If you want to follow 4realey and Myers and use a short-term ris*less rate of interest and an arithmetic excess return on stoc*s over short-term government bonds, a ris* premium of about :B is also acceptable% Combining these numbers, my estimate of the all-equity cost of capital is :#8B F #>=x9B ".B Gsing a B mar*et ris* premium, the rate is :#8B F #>=xB "">B !he all-equity value of MW Petroleum !he present value of the free cash flows in )xhibit 9 $lines "< and .#% discounted at ".B equals E=:: million $!he corresponding figure discounted at "">B is E".8 million% 7alue of interest tax shields 4an*s will lend up to #B of the value of proved developed reserves !he present value of the free cash flows from proved developed reserves appearing in )xhibit 8, discounted at ".B is E8<.. $!he corresponding figure discounted at "">B is E=#:" million% @alf this amount is E"<>" million &pache's borrowing rate on MW acquisition debt is uncertain !he company is presently 4a8 rated, which is equivalent to 44, but it will be pushing the envelope on MW financing, and the last paragraph of the case mentions 4-rated debt I will assume a rate equal to the average of 44 and 4 as shown in )xhibit "# for 0eb <", or "=:B ?ther rates in this neighborhood are, of
course, defensible $6ote the large spread between 44 and 4 rated debt 44 is investment grade, while 4 is /un*% &pache's first year interest expense will thus be E.< million What will it be in following years( When valuing companies with indefinite life expectancies it is plausible to assume this figure will be constant in perpetuity, or even grow with the firm's cash flows 2uch assumptions appear inappropriate here &pache is using aggressive financing, so it is probable that the lenders will push for expeditious reduction in the debt outstanding &nd because MW is a wasting asset, it is impossible to argue that it will be able to support constant or growing debt levels ?ne reasonable approach is to assume that debt outstanding will continue to equal #B of the value of proved reserves and will decline as this value declines & similar, but simpler approach is to assume interest expense declines in proportion to cash from operations $line
"9% from proved reserves, or <:B per year $-<:B is the I33 from investing E<=9 million at time " and receiving E... million at time "% !he value of &pache's annual tax shield is the interest rate times the company's marginal tax rate Hnowledge of the marginal corporate tax rate in the G2 in the early "<<#s, or comparison of 6et income before taxes $line "#% with Profit contribution $line "% in )xhibit 8, suggests a marginal rate of about 8B & fundamental principle is that the discount rate employed should reflect the ris* of the cash flows discounted @ere the cash flows are interest payments to creditors, which are quite predictable 2o a plausible discount rate is the borrowing rate on the debt, or "=:B 2omewhat higher rates could also be /ustified $!his rate is higher than my all-equity cost of capital, but remember that costs of capital are after-tax numbers while "=:B is before tax 0or an explanation of why we want a before tax number when discounting tax shields see the footnote in & 6ote on 4usiness 7aluation on the class Web site% &pplying the perpetual growth equation with next year's cash flow equal to E"#. million $8xE.< million%, a discount rate of "=:B and a growth rate of A<:B, yields a present value of tax shields equal to E=" million $"#.KL"=: - #<:% !his number is li*ely too high for at least two reasons 0irst, it ignores the partial offset of corporate borrowing at the level of personal taxes, and more importantly, it ignores all costs of financial distress due to debt financing I will consider these factors in my answer to question 9 below ?ne might also consider them here as part of a comprehensive discounted cash flow valuation Wherever you consider these factors, you should consider them somewhere !he case $page % mentions E. million in other opportunities, saying that both parties had apparently agreed to this figure My estimated value of MW Petroleum is thus E# million $E=::FE="F.#% > $"# points% 1escribe any real options that might be embedded in the MW Petroleum acquisition In qualitative terms, how might these options, if any, affect the value you calculated in question ( Important real options are embedded in this investment &cquiring MW Petroleum gives &pache the right but not the obligation
to develop three categories of reservesD the proved undeveloped, the probable, and the possible reserves 0or each of these categories, the case notes $pages =-% that significant expenditures are required for further study, engineering, and development, and that such
expenditures may be deferred for up to -9 years without losing the opportunity to ma*e them 4ecause oil and gas prices have been so volatile, these options are plausible quite a bit more valuable than a conventional 1C0 valuation would suggest !he idea is simply that &pache can choose not to ma*e these expenditures if energy prices ma*e then uneconomic 9 $"# points% &ssuming financing is available and ignoring any embedded options, recommend an opening bid and a wal*-away bid for &pache in its negotiations for MW Petroleum &ny reasonable answer is satisfactory here !he answer should be related to the estimated 1C0 value &nd it should reflect any irreducibles that affect value but are not captured in
the numerical analysis Candidates include the fact that the case cash flows appear not to include &pache's superior cost structure as well as failure to include distress costs and the offset created by personal taxes in estimating the value of interest tax shields !he answer should also reflect some *ind of negotiating strategy in pic*ing an opening bid My bidding strategy would be to wor* /ointly with &moco to refine the cash flow pro/ections contained in the case, possibly pushing for more conservative price pro/ections and reserve estimates if my independent sources of information could /ustify them @owever, I would accept &moco's estimates of operating costs, hoping not to reveal
improvements &pache could achieve My opening bid would be the resulting 1C0 estimate of MW's all-equity value Gsing my existing figures, this would be E"8 million I would be willing to raise my bid to include about half of the value of the interest tax shields and half of the savings I expected to reap from &pache's more efficient operations !his would probably put my wal*-away bid somewhere in the range of E9 - E>## million
Mw Petroleum Case
MW Petroleum Corporation
2ituation ?verviewD &moco Corporation conducted an extensive review of its cost structure and profitability, leading to ma/or restructurings to better focus on its core businesses !he result of this was a divestment of the middle section of its assets along the marginal curve !hus, creating MW Petroleum Corporation A a new, free-standing exploration and production oil and gas company MW was offered to a number of targeted international petroleum concerns, but the most attractive offer came from &pache Corporation In late "<<#, the group of &moco Corporation and &pache Corporation began tal*ing in regards to the possible acquisition of MW Petroleum Corporation from &moco to &pache If the acquisition pushes through, it will provide &pache a great opportunity as well as becoming one of the largest acquisitions since MW's si+e is two times larger compared to &pache's current operation 6onetheless, &pache must first carefully evaluate MW's value to come up with a proposal that would be attractive for &moco and profitable for &pache as well !he following paragraphs will discuss the latter
" In the lights of low oil and gas price in the mar*et, big companies, such as &moco see* to restructure in order to increase profitability &moco's plans are to reduce its capital and exploration that are not generating significant returns or the company not having advantage with the returns !he intention of the company is to review its assets with an eye toward selling unprofitable properties or business lines that do not meet its ob/ectives 1oing so, will allow &moco to improve their operating efficiency &pache Corporation's strategy is rationali+e and reconfigure by acquiring inefficient assets and turning them around via cross cutting !he turnover assets can be retained or sold to other buyers With such efforts, &pache is attempting to improve their oil-gas ratio to hedge against the high volatility of gas prices &pache also wants to be more geographically diversified and acquiring new assets, such as MW, enables the company to do that
6ow, it is more reasonable to have &pache operate MW Petroleum for a couple of reasons ?ne, the high over-head cost under &moco, the operation is not as profitable ?n the other hand, &pache has a lot of room to do cost cutting !wo, since &pache's ob/ective is to expand and rationali+e their properties, adhering to their strategy of growth would require them to develop and acquire oil and gas reserves !hus, MW Petroleum would allow for &pache to double their reserves in the future !his investment can lead &pache to increase their assets and investors, and overall, the deal is li*ely to be a win-win situation for both parties, if they can reach a reasonable price to accept
0urthermore, between the two companies, the MW Corporation is more valuable for &pache, because it would bring benefit for them by expanding their properties and generating income through the stabili+ation of a better oil-gas ratio, a diversified geographic location, and an increase in the number of oil and gas reserves Net, if MW remains with &moco then it would be part of the least profitable properties &pacheOs main source of value is to expand and diversify their asset base while the &mocoOs main source of value is to limit their cost, and eliminate the business with a less profitable In essence, acquiring MW would be the most beneficial for &pache because not only will it be good for production, but also with enlarging the ability of &pache to ta*e on more debt
. 1C0 valuation is a popular method used in valuations of a pro/ect or asset by using time value of money &ll estimated cash flow is discounted to present values using the discount rate which is the cost of capital incorporated with the ris* of the pro/ect !he MW Petroleum 3eserve is composed of Proved, Probable and Possible 3eserves !he unlevered beta of equity was calculated using )xhibit ., #:., with a ris*-free rate of :.=B $the 8# year government bond%, and a ris* premium of :B !herefore, the unlevered cost of equity resulted in "8#89B !o calculate the tax shield, we used
tax rate income tax provision with a ".B cost of debt 4y using the 1C0 valuation and )xhibit 9, the 6P7 is =9.= and 6P70 is :8.: while the total &P7 is 9 million
!he estimate is biased high because it is prepared by the seller sideQ &moco and Morgan 2tanley It is up to &pache's operation
management to decide if they can actually achieved such operating cash flow and how efficient they are in terms of executing the cost cutting efforts @owever, at the same time, the 1C0 method did not ta*e into the consideration the time we have to exercise the option, which gives the options more value than exercising right away !he combination result, in sum, can be ambiguous
8 MW can be thought of as a combination of assets-in-place and options &ssets-in-place pertain to properties that already provide cash flow In this case, the machineries deployed in the proved developed reserves as well as all the proved developed reserves would be most appropriate !he option will be depend on whether or not we are spending capital expenditure to further exploit the other reserves $proved undeveloped, probable, and possible reserves% in each case &lso, the company has the option to spend money to further explore
the area in hopes for more reserves to be discovered and find new ways to optimi+e production !his approach could yield a lower value than &P7 that was employed above because it ta*es into account the time value and the ris* of the pro/ect
= Moving forward, we would use the 6P7 of proved developed reserve segment as the estimate of the value of assets-in-place for MW Petroleum, since the whole segment is largely developed $with machinery deployed% with minimum C&PR in the future &s a result, we see the cash flow from this segment as the cash flow generated from the assets-in-place from MW Petroleum
Gsing &P7 method, we have the total value of proved developed reserve asD
0or the ris* of the asset, we would use the revenue of oil and gas as the weight and their price standard deviation to calculate the weighted-average standard deviation of the operation for each year of a particular segment, and average them out in the pro/ected hori+on 0or proved underdeveloped, 21 is #=9 with a P7 of cash flow of >9:9, and C&PR is =<= We use the 8#-year government bond rate, :.=B, as the ris*-free rate !his results in an option value of ==== million
Gsing the same method, we can calculate the option for probable reserves as =.9> and 8#8 &ll these numbers plus the assets-in-place value give the total value of the company, 8 million
6ote, that for the option value calculation, we also assumed that the average lease for the reserve is > years $the median value of the -9 years range for the company to exercise the rights to exploit%
&ssuming a sale goes through, &pache should exercise their option before the expiration of the option In theory, the option will have the highest worth at the expiration day @owever, in the case of MW Petroleum, they should exercise the option before it is matured MW Petroleum has even a bigger si+e than &pache 4y ma*ing the transaction, &pache will be heavily leveraged to fund the acquisition 0or the company itself, exercising the option can provide additional revenue stream and eventually more cash flow to cover high interest payments !o the lending ban*s, they will lend according to the value of the proved reserves !his creates some incentives for &pache to ta*e on the option and discover more proved reserves to have a better lending environment and liquidity 0urthermore, when the new operation gets launched and, assuming properly managed by &pache, the company can have the flexibility to either sell the operation to another buyer to pay down debt or obtain it for future cash flow
Mw Petroleum
Company 6ameD MW Petroleum
&moco Corporation was the fifth largest oil company in Gnited 2tates with .: billion in operating revenues and "< billion in net income !he low oil prices in the "<:#s depressed the profitability of many oil companies and most of which responded with downsi+ing and other cost cutting measures aimed at overhead expenses &moco had already sold more than 9# million worth of small properties, which it felt could be more economically operated by companies with low overhead costs &moco conducted an extensive study on capital structure and profitability in "<:: and found that :B of its margin in Gnited 2tates was provided by ""B of its producing fields and rest had disproportionately high overhead costs and repair costs 4ased on this a strategy was formed to divest up to ". billion worth of additional properties
&s the spinoff could ta*e almost two years it was decided to assemble the properties in a new free standing );P company called MW Petroleum In the "<<#s MW was up for sale and &pache expressed interest in the deal &pache, a 1enver based operator of small-medium si+ed properties was an efficient and cost effective company and the business strategy was to rationali+e and reconfigure !he strategy involved acquiring and controlling producing properties, and quic*ly turn around the efficiency
&pache was specifically interested in MW as it was a large company that would more than double &pache's reserves and was comprised of properties well suited for its operating capabilities More over adding MW would reconfigure &pache's ?il-Sas ratio from .#-:# to =#->#, which was highly desirable for &pache, due to volatile gas prices &lso MWs properties would further diversify &pache's operation geographically @ence MW properties were more valuable to &pache than &moco &pache's expertise in controlling overhead costs could ma*e the difference
In order to calculate P7, we need unlevered cost of capital Gnlevered $asset% Ju #:. $0rom )xhibit .%
3is* 0ree 3ate :#8 B $)xhibit "#, Considering "# year G2 !reasury bond rates%
Mar*et Premium B
Gnlevered cost of capital 3u 3f F Ju $ 3m- 3f% :#8 F #:. $ % ".=B
6P7 Gnlevered
&ssuming that &pache will maintain the capital structure after acquisition
Weighted &verage Cost of Capital W&CC( Gnlevered Cost of Capital 3u ".=B
&verage 1K) ratio #8B T #B &verage !ax 3ate 8==B
Cost of debt ".8B $0rom )xhibit "#, Moody's 4a8 equivalent to 2;P 44%
W&CC $# x ".=% F $# x ".8 x L"-8==B% "#.= &P7 Gnlevered 6P7F P7 of !ax 2hield
&P7 =:>: F :#:: >9>: M E
!he estimate is most li*ely biased low as the initial debt value is fairly low ?ne reason is due to the assumption that additional assets are options and cash flow is mostly deriving from further exploration decisions ¬her reason is the method chose to calculate the P7 tax shield !o find the P7 tax shield, the pro/ected tax expenses was used, calculated the tax shield for each year, and discounted the tax shield with cost of debt !he mar*et premium could be a source of bias as
well &s the mar*et premium increases, &P7 estimate tend to be lower than pro/ected above
!he MW assets can be considered as a portfolio containing assets in place and real options !he Proved developed 3eserves is considered to be the assets in place !he rest of the reserves li*e proved undeveloped reserves $as it needs 8M investment to bring this reserve in to production and management can always chose to produce or not to%, probable reserves, possible reserves are considered to be options !here are . M worth other opportunities, and this cash flow is mainly derived from further exploration &gain this can be considered as an option because if the management doesn't chose to ta*e this option, the stream of cash flow simply won't exist !hese options are similar to call options and 4lac* ; 2choles model can be used to find out the values of these real options !hese real options estimated are generally more than the &P7 estimates as it accounts for the cash flows that can arise from exercising a particular option @owever if we do a sensitivity test, we could see some instances the real option pro/ections are falling, depending on the interest rates, volatility etc
3eal options
6P7 6P7 Proved 1eveloped 3eserve F 6P7 $3eal ?ptions% 6P7 Proved 1eveloped 3eserve
Proved undeveloped reserve Incorporating Capex
$"88%F"9 =.
?ption is valid for -9 years &ssuming average option duration of > years
&ssuming 7olatility U # $Page > Gnder 3is*s price deviations were nearly #B%
2 :8", R =>, 3is* free rate :#8, d" "=<>>, d. #.9"<, 6 $d"% #<8.9, 6 $d.% #>#9"=
Call value C 2 6 $d"% A R e-rt 6 $d.% :8" x #<8.9 A => x e $-##:#8 x >% x #>#9"= >#=>
6P7 Probable 3esrves
2 9=#, R 89, r :#8B, d" ">#""<, d. #89>==<, 6 $d"% #<=888, 6 $d.% #>=>9#:
Call value C 2 6 $d"% A R e-rt 6 $d.% 9= x #<=888 - 89 x e$-##:#8 x >% x #>=>9#: ><
6P7 Possible 3eserves
2 :, R <#8, r :#8B, d" #<>"., d. -#.>8..", 6$d"% #:8":, 6$d.% #8<>"<#
Call value C 2 6$d"% A R e-rt 6$d.% : x #:8": A <#8 x e$-##:#8 x >% x #8<>"<# =<#>
3eal ?ption
!he maximum offer price for MW petroleum : Millions
!he maximum offer price for MW petroleum : Millions
&ll these assets are sensitive to volatility of ?il ; Sas Price, Maturity duration, interest rate of debt etc Siven the political conditions in early nineties it could be concluded that prices were highly volatile !he volatility was around #B at the end of Vanuary "<<" whereas early "<<# the volatility was around 8#B !he volatility can be estimated based on the historical data
& sensitivity analysis on maturity options shows that the offer price increases with maturity, volatility and interest rate &pache can differ the proved undeveloped ; probably reserves from -9 years !o ensure
sufficient cash flows, it is advisable to defer the options as shown below
3aising enough finance is also a challenge for &pache and differing option exercise can ensure that sufficient cash flows streams are established before &pache start exercising options one by one
ConclusionD !his deal will be a good opportunity for &pache to expand its business and add shareholder value !he only foreseeable hurdle is &pache's ability to raise the capital 4ased on the situation &pache
could loan only #B of the proved reserves value In order to raise the rest of the amount it could wor* out a deal with &moco, either to guarantee &pache's external debt or by stri*ing a production sharing agreement
