American call option on the net cash flows

Assignment Help Financial Management

Reference no: EM132425096

In this assignment, you will value PUD of MW Petroleum as a real option.

1. Explain why PUD is essentially an American call option on the net cash flows that follow from capital expenditures required for development.

2. What is the strike price of the call option, X? Refer to Exhibit 4, which shows capital expenditures of $17.5 in the first year and $17.7 in the second year. Assume discount rate equal to the risk-free rate 8.24%.

3. What is the value of the underlying asset, S? This is the value of the asset if PUD were already developed, i.e. if the extraordinary capital expenditures needed for development weren't required. Calculate the present value of cash flows provided in Exhibit 4 but excluding the capital expenditures in years 1 and 2, and discounting at the rate of 13% (just like you did in Assignment 1).

4. Based on your answers to questions 2 and 3, is the call option currently in the money?

5. What is the time to expiration of the option, T? How long can Apache wait to develop the reserves? Find that information in the case.

6. Next, and finally, we should calculate the volatility of the underlying asset. Critique the following estimates as proxies:

a. Volatility of oil and gas prices. Is it constant? Refer to Exhibit 8.

b. Volatility of stock prices for a portfolio of close competitors to Apache

7. If Apache does no hedging, and if it faces fixed operating costs (e.g., overhead), what can you say about the volatility of its assets, relative to volatility of oil and gas prices?

8. Use T=6, volatility of 0.4, and risk-free rate of 8.4%. Use X and S from earlier questions. Assume no dividends. Value the real option on PUD. Compare the value to the DCF value of PUD that you computed in Assignment 1. What can you say about the value of PUD if calculated with these two methods? Which method makes more sense to you?

Reference no: EM132425096

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