Purchase Solution

# Finance: risk neutral probabilities, and value of equity

Not what you're looking for?

Review Questions. 10-2 and 10-3 (attached)

----------------

Given
Available gas (MCF) 50,000,000
Price of Gas (today) \$14.03 per MCF
Gas Price Next Year
High \$18.16
Low \$12.17
Forward price for next year \$14.87
Development cost per MCF \$4.00
Debt (on the property) \$450,000,000
Interest rate on debt 10%
Debt maturity 1 year
Risk free rate of interest 6.0%
Income tax rate 0.0%
Option Exercise price/MCF \$13.90

Solution
a. Hedging (with futures) analysis
Revenue (hedged)
Less: Development cost
Less: Interest expense
EBT
Less: Taxes
Net Income

Less: Principal Payment \$(450,000,000)
EFCF

Estimated value of the equity

b. Real Option analysis
High Price for Gas Low Price for Gas
Revenue (Not hedged)
Less: Development cost
Less: Interest expense
EBT
Less: Taxes
Net Income
Less: Principal Payment \$(450,000,000) \$(450,000,000)
EFCF

Calculating the risk neutral probabilities
Risk Neutral Pbs Option Payout Product
High price oil
Low price oil
Sum
Risk Neutral Expected EFCF
Equity Value

c. Valuing a Call Option on natural gas with an exercise price of 13.90 per MCF
Option Payouts Risk Neutral Pb Product
High price oil (\$18.16/MCF)
Low price oil (\$12.17/MCF)
Expected Payout
Call Value
-------------------------------------------

Given
Available oil (barrels) 20,000
Oil Price Next Year
High \$50.00
Low \$35.00
Forward price of oil for next year \$40.00
Development cost \$600,000.00
Extraction cost/barrel \$8.00
Risk free rate of interest 5%
Income tax rate 0%

Solution
If the investment is hedged by selling the oil in the forward market
Revenue (hedged)
Less: Development cost (600,000)
Less: Extraction cost
EBT
Less: Taxes
Net Income

EFCF

Estimated value of the equity =

If the firm waits until the end of the year to decide whether to exercise the option to develop
Oil Price Scenario
High Low
Revenue (Not hedged)
Less: Development cost (600,000) (600,000)
Less: Extraction cost
EBT
Less: Taxes
Net Income

EFCF

Calculating the risk neutral probabilities
Risk Neutral Pbs Option Payout Product
High price oil
Low price oil
Sum
Risk Neutral Expected EFCF
Equity Value

-----------

PROBLEM 10-3

Strategy of shorting calls and going long on the project
Call strike price \$13.90
Market (traded) price of call per MCF \$1.86
Number of MCF \$50,000,000.00

At time t = 0
Proceeds from shorting call
Investment in project (50,000,000.00)
Net proceeds at t = 0

At time t = 1
High Price Low Price
Gas price \$18.16 \$12.17
Payoffs on short call
Proceeds from project
Net proceeds at t = 1

##### Solution Summary

This solution provides a complete computation of the given finance problem formatted in Excel.

##### Solution Preview

** Please see the attached file for the complete tutorial **

PROBLEM 10-2

Given
Available oil (barrels) 20,000
Oil Price Next Year
High \$50.00
Low \$35.00
Forward price of oil for next year \$40.00
Development cost \$600,000.00
Extraction cost/barrel \$8.00
Risk free rate of interest 5%
Income tax rate 0%

Solution
If the investment is ...

##### Balance Sheet

The Fundamental Classified Balance Sheet. What to know to make it easy.

##### Marketing Management Philosophies Quiz

A test on how well a student understands the basic assumptions of marketers on buyers that will form a basis of their marketing strategies.