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CORPORATE FINANCE (DR.

GERALD POLLIO)

DATA

Lag time of the project = 2 Years


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;

S o = $12 x 50,000 x (1 + 0.05)


−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.

Underlying offshore oil property offers production revenue of 5% of the 50 million


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)

BLACK SCHOLES MODEL

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

C = S 0  (d1 ) − Ke − rT  ( d 2 )

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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)

Hence, S 0 ⇒ S 0 e −δT we get

C = S 0 e −δT  ( d1 ) − Ke − rT  ( d 2 ) ……….. Equation 1

Also, in case of non-dividend paying model, d1 is

 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.

Replacing r ⇒ r − δ , we get d1 for a dividend paying options we get;

 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

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d 2 = 1.0359 − 0.03 × 20

d 2 = 0.2613

ormal Standard Deviations of d1 and d 2 are:

N ( d1 ) = 0.8498
N ( d2 )= 0.6030

Therefore, value of the option is

−0.05×20
C = 544 .22 ⋅ e ⋅ (0.8498 ) − 600 ⋅ e −0.08×20 ⋅ (0.6030 )

= 170.1362 - 73.046 = $ 97.09 millions

COCLUSIO

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

NPV= 544.22- 600= $ -55.78 millions

Black Scholes Model reveals actual value of investment opportunity to be highly


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

= $ 97.09 millions / 3 = $ 32.36 millions

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

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