Question

East Texas Energy Inc (ETE) is considering a investing in a new oil reserve. The project will cost $71 million up front and is expected to generate cash flows during each of the following three years, with the amount of cash flow directly related to oil prices. ETE’s finance department has forecast three likely scenarios for oil prices. There is a 10% probability that oil prices will increase, with associated FCF of $40 million per year for three years. There is a 80% probability that oil prices will remain near current levels, with associated FCF of $30 million per year for three years. The third possibility is a 10% probability that oil prices will decline, with associated FCF of $20 million per year for three years. ETE has determined that the required rate of return for this project is 15%.

Now assume that the finance department has re-estimated the probabilities of the three oil price scenarios. All of the other project data will be unchanged. The re-vised probabilities are 40% chance of oil prices increasing, 20% probability of oil prices remaining at current levels, and a 40% probability of oil prices declining.

1. Compute the value of the Real Option embedded in this project.

Answer 1

First, lets put down the facts that the question is providing us -

Project Cost = $71 M

Expected Return/Discount Rate = 15%

Future Cash Flow (FCF) and their respective probabilities -

FCF	$40.00 M	$30.00 M	$20.00 M
Scenario 1	10%	80%	10%
Scenario 2	40%	20%	40%

Scenario 1 -

Return from project per year before discounting = ($40 M*10%) + ($30 M*80%) + ($20 M*10%)

= $4 M + $24 M + $2 M = $30 M / year

PV of Project with discounting = ($30 M / (1+discount rate)¹ + (($30 M / (1+discount rate)² + ($30 M / (1+discount rate)³

= ($30 M / (1+0.15)¹ + (($30 M / (1+0.15)² + ($30 M / (1+0.15)³

= $26.09 M + $22.68 M + $19.73 M = $68.50 M approx.

Value of Real Option in Scenario 1 = PV of Project - Project Cost = $68.50 M - $71 M = $-2.50 M

Scenario 2 -

Return from project per year before discounting = ($40 M*40%) + ($30 M*20%) + ($20 M*40%)

= $16 M + $6 M + $8 M = $30 M / year

PV of Project with discounting = ($30 M / (1+discount rate)¹ + (($30 M / (1+discount rate)² + ($30 M / (1+discount rate)³

= ($30 M / (1+0.15)¹ + (($30 M / (1+0.15)² + ($30 M / (1+0.15)³

= $26.09 M + $22.68 M + $19.73 M = $68.50 M approx.

Value of Real Option in Scenario 2 = PV of Project - Project Cost = $68.50 M - $71 M = $-2.50 M

In both Scenarios the project would result in a loss to East Texas Energy Inc and it would be wise to not invest into it.