Mw Petroleum Case

Question 1

MW reserves are valued at a total of $473.5 million. In order to obtain this value, “Aggregated MW Production and Cash Flow Projections” (Exhibit 7) were discounted by WACC of 13% (Appendix I).

The DCF is biased low because it values MW as if there are no options involved (i.e., as if the investment decision is taken immediately). This ignores the value of the options. More specifically, the DCF does not take into account the fact that it may be optimal to wait and invest only if oil prices go up. Since the DCF assumes immediate investment, but ignores the value of the option to wait, it is considered the lower bound of the value of MW reserves.

Question 2

The ‘proved developed reserves’ is considered as the assets-in-place because oil and gases are currently recovered from that asset and no further investment is required. On the other hand, the ‘proved undeveloped reserves’, ‘probable reserves’ and ‘possible reserves’ are considered as options because those reserves require further investments and development. These options can be regarded as the combination of option to expand and delay. Firstly, the company is not obliged to make those assets operational. Moreover, the company has at least 5 to 7 years to make decision when they want to further develop those reserves, if they decide to do so.

Question 3

In order to determine the value of S for all three options, the “Cash Flows Excluding Investment” data was discounted by WACC of 13%. “Cash Flows Excluding Investment” can be defined as expected cash flows from the project net of the upfront investment (see written calculations in Appendix II). Based on information provided in the case, the capital expenditures in Years 1 and 2 were considered “initial investment” for Proved Undeveloped Reserves. For Probable Reserves and Possible Reserves, capital expenditures in Years 1 through 5 were considered “initial investment.”

The strike price, K, was simply the value of the initial investment. For...