Oil Well Corp. is a new firm that owns a single asset – land that is estimated to hold 2 million barrels (recoverable) of crude oil. The firm has been partially funded by zero coupon bonds, due to mature in one year with a face value of $9 million. The remaining funding is from equity.

After one year, Oil Well could sell the land to Megacorp, a diversified firm. Industry analysts estimate that Megacorp could, at that point, undertake the following project:

• Invest $1 million in equipment. The straight line depreciation rate is 20%, and the life of the equipment is 5 years and there is no salvage value.
• Extract the oil in equal amounts over 5 years. The total operating cost is estimated to be $42 per barrel. Cash flows related to net working capital are minimal and can be ignored.
• The project has an unlevered cost of equity = 8% and will be partially funded through $800,000 of bank debt with the following specifications:
  • 5 year maturity
  • Issued at par
  • Annual coupon of 4%
  • Principal repayment is at the end of the 5 years
  • The bank will charge $20,000 of fees upfront that can be amortized over the life of the loan.

Alternatively (and, as before, at the end of the year), Oil Well could sell the land for $8 million (instead of selling it to Megacorp). Megacorp pays 30% tax. Oil Well pays no tax.

Crude oil is currently at $45 per barrel. In one year, analysts estimate that crude oil prices will either go up to $55 or down to $40. Thereafter, it will increase at a rate of 4% per year. The effective risk free interest rate is 3% per year.

Assume efficient / perfect markets. This implies that firms cannot make profits higher than indicated by their cost of equity and cost of debt.

Find:

a) The value of equity for Oil Well

b) The value of debt for Oil Well

c) The value of the firm for Oil Well

d) The YTM on the Oil Well bond.