THE UNIVERSITY OF TEXAS AT DALLAS JINDAL NAVEEN SCHOOL OF MANAGEMENT

FIN 6301 Spring 2014

Assignment 2
Due: April 27, 2014

Diem Nguyen Anh Hai Nguyen

The data of crude oil price are downloading from the most recent update forecast. The Prior Settle is used as the estimated future price for December of each year from year 2014 to year 2022. All the assumptions and analysis received from the company are input in to spreadsheet for production cost as well as net working capital cost calculation. The equipment is depreciated according to MACRS 10-year schedule. Excel function VLOOKUP is used to calculate the accumulated depreciation of the equipment based on the MACRS 10-year schedule. To calculate the break-even purchase price of the land, excel Goal Seek analysis function is used. The NPV cell is set to equal zero by changing the Land price. The Excel function Data Table is used to explain the change in Net Present Value (NPV) with variable tax rates and discount rates. We expected the Table will show the negative correlation relationship between NPV and the change in tax rate and discounted rate. Scenario Manager Analysis function is used to illustrate its effects in the values changes of NPV, IRR, and payback period. As price rise, NPV and IRR are expected to increase while Payback period is decrease. Also as production unit is declined or expense cost is increased, NPV will be negative and IRR is less than the cost of capital as well as longer recovering period. 1. Calculate the NPV of the whole project and calculate the purchase price for the 8year lease which would generate an NPV of exactly 0 (see Figure 1) Net Present Value of the whole project with all of the assumptions as given is $5,765.74. For NPV being exactly 0, purchase price for the 8-year lease should be $5,765.74. The purchase price is calculated by using the Goal Seek option in the What-If Analysis. We set NPV equal to 0 by changing the Land Purchase Price cell. 2. Assume that we can negotiate a price for the lease that is 5% less than the breakeven price. Calculate the NPV, the IRR and the pay-back period of the investment (see Figure 2) The new purchase price should be $5,477.45. NPV = $288.28 IRR = 10.41% Pay-back period = 3.86 3. The head of our company is very uncertain about market conditions, and he believes the cost of capital may change significantly before going ahead with this project. He is also concerned that the U.S. government may make a substantial change in the tax subsidies given to oil producers. Construct a sensitivity table varying the cost of the capital from 8% to 11% and the marginal tax rate from 20% to 28% so that he can visualize different scenarios (see Table 1) 1

What does this table tell you about the relationship between tax policy, the cost of capital, and the incentives of drilling companies to invest in new projects?

Increasing in tax rate and discount rate will cause the negative NPV, which means the cash flows received from the project do not enough to cover the initial investment. As a result, we can say that the project is unprofitable. The table shows that if tax rate is kept constant as the discount rate is increasing, the NPV of the project will be decreased. The relationship between discount rate and NPV is negative correlation. Similarly, if tax rate is increasing while discount rate is kept constant, the NPV of the investment will also be decreased. In conclusion, the relationship between discount rate, tax rate and the projects NPV are negative correlation: as tax rate and discount rate increase, the projects NPV will decrease. Thus, lower the incentives of drilling companies to invest in new projects. Consider the fact that this company is bidding on the rights to lease the land when it performs this analysis. In this scenario, who is likely to capture the benefits of tax subsidies?

There are some tax breaks that benefit the oil company, which are intangible drilling costs and tertiary injectants. However, President Barack Obama proposed the Fiscal Year 2013 called for removing a handful of tax provisions that preferential benefit fossil fuel production and estimated to yield more than $4 billion a year for the Government. The proposal if be activated will hurt the oil industry. The proposal calls for repealing tax provisions for expensing intangible drilling costs, a deduction for tertiary injectants, an exception to passive loss limitations for working interests in oil and natural gas properties, a percentage depletion for oil and natural gas wells, and a domestic manufacturing tax deduction for oil and natural companies. These repeals not only discourage the incentives and diminish job creation. As the reducing in the tax deductions for the oil and natural gas companies, the oil price in the marketplace will have to increase in order to cover all of the expenses and costs. Thus, the consumers will also be hurt by the rising in oil and gasoline price. After all, only the Government can benefit from these reductions in tax subsidies. 4. Scenarios Summary of four different scenarios (see Table 2) Higher Price scenario: Oil price could climb to$130 a barrel in 2016 and remain high Lower Price scenario: Oil price could fall to $55 in 2016 and remain low. Smaller Decline scenario: Production is assumed to decline of 60% in the first year and 20% afterwards. More Difficulty scenario: Drilling costs will be $3.5 million and production will be 320 barrels in the first year. Based on the Scenarios Summary, the increase in oil price definitely will increase in net present value and internal rate of return. Also, since the price rises, the payback period will decrease which means the company will have shorter time to recover its 2

initial investment. Changing in oil prices from $84.83 to $130 a barrel in year 2016 causes the increasing in NPV from $288.29 to $1,402.07, higher IRR from 10.41% to 14.01% and shorter pay-back period from 3.86 to 2.94. Smaller decline of 60% in the first year and 20% afterwards means higher rate of production, which also causes the increase in NPV and IRR and decrease in pay-back period. NPV is increased by $2,287.25 and IRR is increased by 6.33%, while the payback period is decreased by 0.75. In contrast, the decline in oil price (from $84.43 to $55) will lead to the loss in the companys investment. NPV is declined by 55% (from 288.29 to -447.25). The IRR is also declined from 10.41% to 8.10%, which is less than the cost of capital. The more difficult reaching the oil, the more drilling costs and the less production during the year. When drilling costs increased by $500,000 and production declined by 40 barrels in the first year, the NPV will drop to -1,251.89 and IRR is less than the cost of capital. The large negative NPV represented for the unprofitability and inefficiency of the project. Also, the project has a longer pay-back period (5.70 years). Given the outcomes of each of these scenarios, what can you say about the risk of this business? Does the risk in any of these scenarios represent systematic risk? If you believe these scenarios are plausible, which ones should be factored into the discount rate? The risk of crude oil business is relatively high. This high risk is shown in the unpredicted change in price in the first scenario, the declination in production and the increase in expense. As we have mentioned above the effect of these changes in NPV, IRR and Payback period. These factors increase the risk of the company. These scenarios point out the two risks that oil company has to face if they decide to invest in the project: systematic risk and unsystematic risk. Systematic risk is also known as market risk- the risk that cannot fix by diversification. The unpredictable price change in the first scenario is the example of systematic risk. The expected price can go up 53% more from the original forecasted of $84.83 in December 2016 or it can decrease by 35%. Since the company has to expense a large amount of fund for not only for the land but also for equipment and drilling cost and variable cost, the decline in price will hurt the company financial situation such as negative NPV, IRR< r and longer payback period. The price changes due to the condition or structure of the industry or the market. The changes in production unit or growth rate and drilling cost (expense) are unsystematic risks. Unsystematic risks are risk that is specifically for a company. This risk can be reduced by diversification. Drilling cost and production decline are variable in different company and depends on the land. If these scenarios are plausible, scenario ones with the changes in oil price should be factored into the discounted rate because the change in price is systematic risk. Moreover, price change can lead to the change in Net profit margin per barrel. Thus, it can affect the discount rate. A higher price will increase the discount rate. And a lower price will reduce the discount rate.

Figure 1

Figure 2

Table 1: Sensitivity Table

Table 2: Scenarios Summary