investment evaluation

| November 25, 2015

Question 2
Morrison Oil and Gas is faced with an interesting investment opportunity. The investment involves the exploration for a significant deposit of natural gas in southeastern Louisiana near Cameron. The area has long been known for its oil and gas production, and the new opportunity involves developing and producing 50 million cubic feet (MCF) of gas. Natural gas is currently trading around $14.03 per MCF; the next year, when the gas would be produced and sold, could be as high as $18.16 or as low as $12.17. Furthermore, the forward price of gas one year hence is currently $14.87. If Morrison acquires the property, it will face a cost of $4.00 per MCF to develop the gas.

The company trying to sell the gas field has a note of $450 million on the property that requires repayment in one year plus 10% interest. If Morrison buys the property, it will have to assume this note and responsibility for repaying it. However, the note is nonrecourse; if the owner of the property decides not to develop the property in on year, the owner can simply transfer ownership of the property to the lender.

The property’s current owner is a major oil company that is in the process of fighting off an attempted takeover; thus it needs cash. The asking price for the equity in the property is $50 million. The problem faced by Morrison’s analysts is whether the equity is worth this amount. (Answer the following assuming zero taxes)

a) One possible response to the valuation question is to estimate the value of the project where the price risk of natural gas is eliminated through hedging. Estimate the value of the equity in the project where all the gas is sold forward at the $14.87-per-MCF price. The risk-free rate of interest is currently 6%.

b) Alternatively, Morrison could choose to wait a year to decide on developing it. By delaying, the firm chooses whether or not to develop the property based on the price per MCF at year-end. Analyze the value of the equity of the property under this scenario.

c) The equity in the property is essentially a call option on 50 MCF of natural gas. Under the conditions stated in the problem, what is the value of a one-year call option on natural gas with an exercise price of 13.90 MCF worth today? (Hint: use the binomial option pricing model).

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