Question 2

Today is 1^st June 2020. Permian Partners (PP) produces and sells crude oil. Production was 1.8 million barrels for the year ended 31^st May 2020, but the production is expected to decline by 7% per year for the foreseeable future. Costs of production, transportation and administration add up to 25 per barrel and will remain unchanged. The average oil price was 65 per barrel for the year ended 31^st May 2020. PP has 7 million shares outstanding and its cost of capital is 9%. PP distributes all its earnings as dividends. Assume that the company will stay in business forever and does not pay any taxes.

i.Calculate the value of one PP share today, assuming the following oil prices in the future years.

Year

2021

2022

2023

Oil Price / Barrel

60

55

50

After 2023, assume that prices will increase by 5% per year forever,

but costs per barrel will remain unchanged at 25 per barrel.

Calculate PP's earnings per share to price (EPS/P) ratio as today based on the forecast net revenues for the year ended 31^st May 2021, and explain why it is not equal to PP's cost of capital.