Real Option Valuation

REAL OPTION VALUATION: MW PETROLEUM

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...