An Oil marketing rm in India COI Ltd is currently only in the downstream business

and hence has to procure the crude oil from elsewhere. They plan to enter the

upstream business so as to integrate vertically in the value chain. The project

that you have identied is in Papua New Guinea (PNG). The ministry in PNG

has invited bids for an on-shore reserve in PNG which will give you access to the

reserve for 10 years. You are now thinking of arriving at the best bid price for

this project, which is an upfront payment that is not amortized. The expected

annual sales revenue of the crude oil sales to your reneries (using transfer pricing

method) is provided to you in the Table 1 below. Projections factor in potential

reduction in oil prices given the rapid shift to clean energy. Total costs of production

is 40% of the revenues. The machinery for the rigs would cost you |600 million.

As the machinery is specic to the geography, you are going to depreciate it on

an accelerated basis of 25%. You expect this machine to be sold for |10 million

at the end of the 10 year period. As it is a new product, the rm expects an

initial investment of |25 million in net working capital. Subsequently, depending

on revenues, the net working capital at year end would be 10% of the next year

revenues. The rm expects to recover all the working capital by the end of the

project's life. COI had sent a contingent to evaluate the terrain and the promise of

the oil reserves last year incurring a cost of |5 million. The report was favorable

for investment. The eective tax rate at OCI is 20%.

As the company is venturing into a non-core business, they are contemplating the

right discount rate. The rm management has estimated the asset beta of the COI

Ltd to be 1.2. The market risk premium is 8% and the risk free rate is 6%. In

addition, the management is privy to the asset betas of upstream companies who

are new in this business to be in the range of 1.6 to 1.8. Compute the NPV of

this project assuming that COI plans to use all equity nancing and compute the

amount that can be bid for access to this site if the minimum NPV determined by

management is |50 million after all costs are factored in. Historically, the average

bids for such sites in PNG was in the region of |650 million.

Now, you are contemplating to increase value of this project by going for partial

debt nancing. The creditors are reluctant to grant the loan for 10 years and hence

have oered |200 million for a 5 year period with a condition to repay the principal

in equal installments at the end of each year for the next 5 years. Cost of debt

is 8%. What is the incremental value of debt nancing. What is the NPV of the

project now?

The management is still looking for additional value. The ministry in PNG, given

the strategic interests of the bilateral relations oers you a subsidized debt with the

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same terms as the creditors except for the price, which is lowered to 4%, lower than

the risk free rate. In addition, you have managed to convince the tax authorities

that the machines can be depreciated fully in the rst year. What is the incremental

value of each of these measures. What is the NPV of the project now?

1 2 3 4 5 6 7 8 9 10

Sales revenue (in |millions) 500 550 600 700 750 750 600 500 400 400

Table 1: Projected Sales

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