Hello,

Attached are two files; a Word document with the question and an Excel template. Thank you for your help!

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 50,000 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 Morrision 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) Estimate the value of the equity in the project for the case 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 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). PROBLEM 11-1 Given Available gas (MCF) Price of Gas (today) Gas Price Next Year High Low Forward price for next year Development cost per MCF Debt (on the property) Interest rate on debt Debt maturity Asking price for Equity Risk free rate of interest Income tax rate Option Exercise price/MCF $ $ $ $ $ $ $ $ Solution Legend 50,000,000 14.03 per MCF = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output 18.16 12.17 14.87 4.00 450,000,000 10% 1 year 50,000,000 6.0% 0.0% 13.90 Solution a. Hedging (with futures) analysis Revenue (hedged) Less: Development cost Less: Interest expense EBT Less: Taxes Net Income Less: Principal Payment Equity FCF $ (450,000,000) Present value of expected Equity FCF for year 1 where gas revenues are sold forward (hedged). Discounted at the risk free rate. Estimated value of the equity b. Real Option analysis High Price for Gas Revenue (Not hedged) Less: Development cost Less: Interest expense EBT Less: Taxes Net Income Less: Principal Payment Equity FCF Low Price for Gas Use forward price to calculate the risk neutral probability, i.e., $ (450,000,000) $ Calculating the risk neutral probabilities Risk Neutral Pbs High price oil Low price oil (450,000,000) Option Payout Product Sum Risk Neutral Expected Equity FCF Equity Value c. Valuing a Call Option on natural gas with an exercise price of 13.90 per MCF Option Payouts Risk Neutral Pb Product High price oil ($18.16/MCF) Low price oil ($12.17/MCF) Expected Payout Call Value Buy 50 m calls The option to produce only when conditions are favorable is obviously valuable. It doubles the value of the equity in the gas venture