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You are on page 1of 3

GERALD POLLIO)

DATA

Dividend Yield or Net production revenue

each year δ = 5% of reserves

Current value of the asset: As the current value of the asset must reflect the loss of

production revenues during the delay or the lag time, value of the asset will be

discounted back at dividend yield ( δ ) for 2 years. This reflects the loss of cash flow

during developmental period. Therefore current value of oil field S o is;

−2

= $ 544.22 millions

K = Exercise price = Developmental cost = $ 600 millions

T = Time to expiration = 20 years

R = Risk free interest rate = 8%

σ 2 = Variance = 3%

SOLUTIO

The firms that make natural resource investments have the option to leave the

investments untouched if the price of the resource declines and to exploit them fully if

the price rises. Therefore, extracting the reserves make sense only if the value of

reserves exceeds the development cost. Therefore, a natural resource investment can

be viewed as a call option where the underlying asset is the reserve and the value of

the reserve depends on the quantity and price of the natural resource.

barrels of reserves ever year which is the dividend yield of the asset. As payment of

dividend reduces the assets’ price; the call option under consideration will become

less valuable due to 5% dividend yield on its .

Typical Black- Scholes Model applies to the assets which do not pay dividends over

their life, therefore it do incorporate the effect of dividend yield on interest rate as

well as loss of revenue at dividend yield for the duration of developmental work.

Following adjusted Black and Scholes Model will incorporate this. (Bodie, et al; 2008

p 758), (Mun, J, 2002), (Wikipedia link provided)

For non-dividend paying option the call value is calculated by following expression.

C = S 0 (d1 ) − Ke − rT ( d 2 )

Page 1 of 3

The term S 0 (d1 ) represent the present value of the cash inflows of investment,

therefore in order to accommodate the dividend yield (know as δ ) which decreases

−δT

the value of investment, we further discount S 0 to e [note that e −δT is almost

equal to 1- δ T, so the value of dividend will be approximately δ T S 0 ]. (Bodie, et al,

2008)

S σ 2

ln 0 + r + × T

K 2

d1 =

σ T

To accommodate the dividend yield, we will have to deduct δ from risk free rate r to

reflect the reduction in the carrying cost of the asset.

S σ 2

ln 0 + r − δ + × T

K 2

d1 = ………. Equation 2

σ T

d 2 = d1 − σ T …….… Equation 3

CALCULATIOS

Using equations 1, 2, and 3, we get

544.22 0.03

ln + (0.08 − 0.05 + ) × 20

d1 = 600 2

0.03 * 20

d 1 = 1.0359

and

Page 2 of 3

d 2 = 1.0359 − 0.03 × 20

d 2 = 0.2613

N ( d1 ) = 0.8498

N ( d2 )= 0.6030

−0.05×20

C = 544 .22 ⋅ e ⋅ (0.8498 ) − 600 ⋅ e −0.08×20 ⋅ (0.6030 )

COCLUSIO

The net present value of the investment opportunity using discounted cash flow

method is;

lucrative, fundamentally due to the variance in the oil prices.

As my uncle’s share in investment is one third of the total, the value of which is

REFERECES

• Bodie, Kane, Marcus, 2008, Investments, 7th Ed, McGraw Hill, London

• Mun. Johnathan, 2002, Real Options Analysis: tools and techniques for

valuing strategic Investments and Decisions, Wiley/Finance series)

• Damodaran, A., 1994. Damodaran on Valuation. Wiley, New York, NY.

• http://pages.stern.nyu.edu/~adamodar/

• Wikipedia: http://en.wikipedia.org/wiki/Black%E2%80%93Scholes

• ACCA, Study Text, BPP

Tools

MS Excel and Equations editor

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