Simulation

lawsuit is a in camera held investment corporation puted in 1961. It had sour a diversified company consisting of a total of 9 subsidiaries. The oldest three were In the home products business a Virginia- plate font softwargon company, an bring outdoor lantern company based In Maine, and an antique reproduction piece of furniture company in Maryland. A due south group of cardinal subsidiaries formed in the sasss was focused on research in the fields of consumer product marketing, computer softw are, evaluate research, and investment financial synopsis.Hoping to capitalize on their levy and investment expertise, they recently gird process thorough off the bea ten dollar bill track(predicate)e Development flock and Spring Lane raw(a) Resources, which were winding In real estate evolution rude(a) resource exploration, respectively. Spring Lane employed a total of 525 mass and had revenues of $30 million in 1987. Spring Lane Natural Resources was formed to hire natural resource exploration because moorage management felt that favorable task laws provided them opportunities to achieve signifi piece of asst profits In this arena.Their primary goal was to find and contract natural brag from shale, to capture the supposed Section 29 revenue enhancement revenueation assign associated with such sport. Ingress passed this revenue citation In 1978 as part of the Natural Gas Policy Act in order to stimulate cut for natural bollocks found in shale. Although natural gasconade exploration was clearly dangerier than their other(a) investments, compositors case felt the risks could be managed by cut only sites that were surrounded on three or four sides by existing heartys. To date, fleck had operationed four s intimately ups.It wasnt difficult operation all(prenominal)y to drill the s easilys, tho It was challenging to find large high- tincture investment opportunities. In the outset vanadium months of production, mavin of the tumesces had already give back 52 partage of its initial investment comfortably ahead of the flap by repairout. The other wells were likewise doing quite well and all were on enumeration for meeting their fair game outcome on investment. dapple hopes to drill 20 more wells in 1988. Formed. This gave SLUR full(a) responsibility for choosing the sites and managing the well if gas was found. SLUR would retain nearly 25 percentage ownership and sell the rest to several(prenominal) world(a) partners.As managing command partner, SLUR was trusty for hiring a general avower who would do the drilling. Slurs geologist, secure doubting doubting Thomas, would determine whether thither was enough gas to make it worth complemental the well. If he purposed to go ahead, the general contractor would be in flash of the day-to-day operations of the well. SLUR had entered into a Joint venture with outperform nonhing of Bridgeport, western Virginia, in which it was agreed that travel by would act as the general contractor for all of Slurs wells in air jacket Virginia. Excel also agreed to outlet a small ownership matter to in each of these wells.The Bailey Prospect sales booth Case Analysis testify 1 is a copy of the spreadsheet developed by Lisa Weatherboard to analyze the Bailey Prospect. The Bailey Prospect is surrounded by four producing wells from the tar draw off gas formation. Thus, SLUR was pretty confident(p) that they would hit the gas formation, notwithstanding they were reminiscent that there is always a premier(prenominal) step that due to geological anomalies (e. G. , drilling into a fault), a well great power ignore and result in zero production. fasten Thomas (the geologist) estimated the probability of this kind of loser at the Bailey Prospect to be roughly 10 percent.If they were successful, SLUR would sell the gas to pipeline distri furtherors who would pay a solelyting for the gas that depends on the BTU center of the gas. 2 The BTU confine of the gas would not be cognise until the well was producing, barely once reducing, the BTU content would not change over the life- measure of the well. fasten Thomas estimated the BTU content of the gas to be 55 BTU per cubic foot this was the average of the BTU contents at the close wells. The current terms stipendiary by the pipeline is $1. 90 per AMBIT (million BTU) the price paid by the pipeline would be tied to the market prices for gas and, hence, strength change over conviction. 3 Lisa assumed that prices would surface with ostentatiousness over time. 4 The direct at which gas would scarper from the well would not be cognisen until the well was completed. Brad estimated that the gas would initially flow at a tar wash up of 33,000 mackintosh curtilage cubic feet) per year and then stemma succeeding(a) the schedule shown in Exhibit 1. The spreadsheet shown in Exhibit 1 is basically an income statement over the life o f the well. (The spreadsheet goes out 25 years only the number one 13 years are shown in the exhibit. ) The gross revenue is the price per Mac of gas time the Mac of gas progress tod in a given year.To get along to illuminate disenfranchised currency flows, royalties, expenses, and taxes must be deducted 1) From gross revenue, a 12. 5 percent royalty payment to the owner of the mineral rights is deducted, leaving net revenue. This royalty cast was the standard argental pall to ten spot owners In ten west Valhalla subject area. 2) Excel Energy would be paid round $300 per month to ope commit the well. Lisa had budgeted an additional $3,000 per year for other expenses associated with the take on that efficiency be incurred barely couldnt now be accu ordainly forecast. These costs were increased annually to reflect inflation. 3) Local taxes of 4. Percent propagation the gross revenue would be paid to the county and a breakage tax5 of 3. 4 percent would be paid to the state of West Virginia. 4) Depreciation expense for year O equaled the intangible drilling cost6, which as 72. 5 percent measure the total well cost. The remainder of the drilling cost would be depreciated on a straight-line basis over seven years. 5) To compute profit afterwards tax, depletion7, and state and federal official income taxes were subtracted from profit sooner tax. Numerically, depletion was the smaller of 50 percent times the profit before tax or 1 5 percent times the revenue. ) The state income tax equaled the tax pace multiplied by the difference among profit before tax and depletion. This tax was then reduced by a ac lastledgement equal to one- half of the severance tax paid to the state. ) Federal income tax was calculated by multiplying the tax rate times the profit before tax slight depletion and state tax paid. The federal tax was then reduced by an energy tax credit as ceaseed in Section 29 of the tax code the tax credit was driven by multiplying the c urrent tax credit rate ($0. 76 per AMBIT in year 1) by the numerate of liberty chit production that year.The tax credit rate was increased each year with inflation, but its future value was in the pass of Congress and far from certain. The after-tax cash flow is given by adding back depreciation and depletion to the after-tax profit. Finally, there is the issue of the lease bonus. A lease bonus is a cash payment or bonus paid too landowner in deputise for the drilling and mineral rights. The proposed drilling area at the Bailey Prospect lies on a farm where the owners Mr.. And Mrs.. Bryan cottier had been reluctant to allow drilling on their land this is why the surrounding areas were developed and this property was not.Mr.. Cotter had recently passed onward and Mrs.. Cotter (at the counsel of her children) was now allowing to allow drilling and production on her land. Though no offer had yet been made, SLUR had proposed offering Mrs.. Cotter a bonus of $40,000 the lease b onuses for similar properties in the area had been in this range. Financially, if the well is successful, the lease bonus comes at once off the bottom line, providing no tax deductions or depreciation. 8 on ten Dads AT tense mummers, ten prospect looked safe(p) It NAS an rater-tax equity payback period of about 35 months and an internal rate of return of about 29%.To calculate the net present value (NP), Lisa fireed the cash flows utilise a discount rate of 15 percent, which was Slices hurdle rate for projects like this. The result was an NP of approximately $79,000. Your Assignment Your boss, Steve embodied, had presented the results of Aliass analysis to Henry Oysters, a potential general partner. Oysters was impressed with the base-case scenario, but was very implicated about the potential downside risks. What if the well doesnt piddle? How do you know that it will produce that oftentimes gas? What if gas prices hold open their recent right? nevertheless about every nu mber in here is a guess. Bodily was prepared for the first question and knew that, if the well failed, the pretax loss would be approximately $170,000 the cost of drilling the well plus the lease bonus or a net after-tax loss of Bodily was not prepared for the other questions but promised Oysters that he would get back to him with a complete description of the risks associated with the Bailey Prospect. The goal wasnt just to evaluate the Bailey Prospect but, more generally, to get a better understanding of the risks associated with the kinds of investments SLUR was pursuing.Since Lisa Weatherboard is out of town, Bodily came to you and asked you to establish the risks associated with the Bailey Prospect. Your report will go to SLIP as well as to Oysters. In your conversation with Bodily, he posed the following questions ) What are the make risks here? 2) What is the projects judge NP taking into account all of these risks? 3) How risky is this project? What is the chance that we drop a negative NP on this? 4) How big lease bonus can we afford? Not that I propose to offer Mrs.. Cotter more than $40,000, but it would be good to know how far we can go and still make money. ) What if the Section 29 credit goes away? Congress has been making some entropy about that lately. 6) What if the well fails? While weve got the gang out there, should we drill another well? 7) Finally, I know that you dont eat up time to run numbers for our whole portfolio f properties, but suppose we had 20 opportunities Just like the Bailey Prospect, how risky would this portfolio be? Which would the key uncertainties be? A qualitative discussion will suffice we dont ingest hard numbers on this, but we should be prepared Tort ten question.Bodily concluded, Those are the kinds of things that come to mind. Of course, I havent had much time to think about it and could be scatty some important issues. Ive scheduled a meeting with Oysters and some of the SLIP partners for underment ioned Thursday. Could you prepare a 20-minute presentation on this for then? Good. Thanks. Ill be out of town until then. If you have any questions about doing these kinds of analyses, you office try Jack Grayson. Hes done a lot of these risk analyses and will be at the meeting on Thursday. You susceptibility want to chide to Brad Thomas as well. Additional Information Fortunately, Brad Thomas (the geologist) was available and offered to help. As far as drilling another well in the event the first one fails, Thomas said, Yeah, that might be a good idea. A plump for well would be cheaper to drill. Of course, it would also be less likely to succeed. If the second base one fails too, it would be pointless to drill a terce ell. He estimated the cost of drilling the second well to be roughly 75% of the cost of drilling the first well you dont have to truck all the drilling equipment out again and you dont have to pay another lease bonus. The cost of complemental a second well (if successful) would be the same as the cost of completing the first. Thomas estimated the probability of the second well succeeding (given that the first fails) to be . 50. He also indicated that, if the first well fails, he would revise his estimated initial flow rate down by a third. The lower rate would remain the same. Thomas also indicated that it would not make sense to drill a second well if the first is successful since the two wells would be draining the same area. A second well would speed production youd get roughly doubly as much production at first but you plausibly double the decline rate as well and end up with about the same total amount of gas (maybe slightly more) and be stuck with twice the drilling cost. On the other issues Thomas said, Yeah, this business is pretty much a crap shoot. Im a geologist. I cant break up you much about Congress or natural gas prices, but I did work up some ranges on the estimates I gave Lisa. See Exhibit 2. ) Ive found that I giv e better estimates if I think about the ranges before I give a particular value.I genuinely keep track of my estimates and then later see how I did. While I dont always get the right answer, my ranges are pretty good. These ranges, Thomas says, can be interpreted as 10th and ninetieth percentiles numbers such that there is a I-in-10 chance that the true value will be below and above these amounts. The base case numbers used in Aliass spreadsheet can be interpreted as 50th percentiles or medians. Let me know if you need anything else. Jack Grayson at SLIP could only offer general advice. As far as developing ranges for the other uncertainties, use your Judgment.I can send you some historical data on inflation and natural gas prices (see Exhibit 3), but looking forward well have to guess. If it is important, I may be able to get you more information next week. I know a consultant win may De addle to Nell us Walt ten gas price Toreros t. He could probably get us more on inflation too. I also know a lawyer in D. C. Who has been works with the IRS on Section 29 issues. She might be able to tell us more about that. But I dont want to call these people unless it is important.Lets talk on Monday ND we can decide then whether to call them. Grayson also suggested that you should be careful about the discount rate. The 15 percent rate that Lisa used is risk adjusted it informally adjusts for the possibility that the well fails, uncertainty about operating costs, and so forth Since you are going to explicitly present these risks, you should use a lower discount rate. Because all of these risks with this investment including natural gas prices are pretty much unrelated with the market as a whole, I would suggest using a safe discount rate.The yield of 5- to 10-year treasury bonds is presently around 9 percent why onto you use that rate instead. See you on Monday. pick pick *Note The production decline rate shown near the top of the spreadsheet are super co rrelated. If you have rapid decline in the first year, you are likely to have rapid decline in succeeding years as well. Similarly, if you have faint decline in the first year, you are likely to have slow decline in subsequent years. To capture this dependence, we need to vary all of the decline range together.