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In less than five, double-spaced, typewritten pages, plus any exhibits, please answer the following questions about MW Petroleum Corp !his assignment is worth a maximum of "## points " $"# points% &part from any quantitative analysis, are there any reasons to anticipate that  &pache Corporation's Corporation's acquisition of MW Petroleum might be a positive net present value activity for &pache, for &moco( )xplain !his loo*s li*e an attractive deal for both parties &moco does many things well, butt ma bu mana nagi ging ng sm smal alle lerr, ma marg rgin inal ally ly pr prod oduc ucti tive ve oi oill an and d ga gas s fi fiel elds ds appa ap pare rent ntly ly is isn' n'tt on one e of th them em !h !his is is a ch chan ance ce to un unlo load ad so some me prope pro perti rties es th that at bec becaus ause e of the their ir hig high h cos costt str struct ucture ure,, &m &moco oco can can't 't manage profitably &pache, on the other hand, has low costs and is an efficient operator of small- to mediumsi+ed properties !he company has ha s gr grow own n si sign gnif ific ican antl tly y in re rece cent nt ye year ars s by ac acqu quir irin ing g le less ss we wellllru run n properties and applying its rationali+e and reconfigure strategy !he MW Petroleum properties appear to offer the opportunity to continue this strategy If &moco can stri*e a price wherein &pache shares some of its operating savings with &moco, &moco, both parties can generate positive net present values from the transaction &cquisition of MW Petroleum may also reduce the volatility of &pache's cash flows by ma*ing them less dependent on gas <hough this may not benefit shareholders directly, it will li*ely enable management to sleep better and might increase &pache's &pache's borrowing capacity, thereby benefiting sharehold shareholders ers indi in dire rect ctly ly . $" $"# # po poin ints ts% % Wh Whos ose e pr pro/ o/ec ecti tion ons s ap appe pear ar in th the e ca case se exhibits( 0rom &pache's perspective, is there any reason to believe these numbers might be biased one way or another( 1oes the value of  MW Pe Petr trol oleu eum m de deri rive ved d fr from om th thes ese e nu numb mber ers s re repr pres esen entt &pa pach che' e's s maximum acquisition price( )xplain !he story appears to be a mixed one on e < ltho houg ugh h &pa pach che e is ca capa pabl ble e of ma ma*i *ing ng it its s ow own n ca cash sh fl flow ow pro/ections, the pro/ections presented are not &pache's In particular, the oil an and d ga gas s pri price ce for foreca ecasts sts we were re com compil piled ed by Mor Morgan gan 2ta 2tanle nley y $repre $re presen sentin ting g &m &moco oco in th the e sa sale% le% !h !he e est estima imates tes of res reserv erves es and annual production figures were generated by independent petroleum engineers $presumably paid by &moco% !he forecasts of direct costs are based primarily on &moco's historical experience, and pro/ected over ov erhe head ad is ba base sed d on am amou ount nts s &m &moc oco o it itse self lf ex expe pect cts s to sa save ve by dives div estin ting g MW MW 3ec 3ecall all,, th the e bas basic ic pre premis mise e of the tra transa nsacti ction on is th that at  &pache can operate the fields more efficien efficiently tly than &moco 4ecause

such efficiencies have not yet been incorporated into the pro/ections, there is reason to believe the direct costs are overstated from &pache's persp pe rspect ective ive 5o 5oo*i o*ing ng on only ly at the dir direct ect co costs sts,, the their ir ove overst rstate atemen mentt suggests that the resulting valuation may be biased low If so, the valua val uatio tion n wil willl be bel below ow &pac pache he's 's max maximu imum m acq acquis uisiti ition on pri price ce,, an and d  &pache could bid above this figure and still generate a positive 6P7 6P7 !he valuation might be viewed more properly as &moco's reservation price, below which it should not sell 8 $.# points% )xhibits 8-9 contain cash cas h flo flow w pr pro/e o/ecti ctions ons for MW Pet Petrol roleum eum !o wh what at ext extent ent do the these se numbers represent free cash flows suitable for use in a discounted cash flow valuation( In particular, please comment on the treatment of  overhead $line :%, financial

boo* 11;& $line %, and terminal value $line .#% <hough one might quibble with some details, I find the exhibits properly represent the free cash flows suitable for use in a discounted cash flow analysis !his is not to say the numbers are necessarily accurate, only that they are manipulated properly in the exhibits ?verhead &s discussed in the 1iamond Chemical case, overhead does not mean fixed 7ariable overhead is relevant to valuing MW, fixed overhead isn't &bsent information to the contrary, it seems appropriate to consider these costs variable !his is a little tric*y !he exhibits calculate profit contribution based on financial boo* reporting numbers !hey subtract financial boo* 11;& to calculate net income before taxes, and then they subtract total income taxes $or more commonly, provision for taxes% to calculate profit contribution $or more commonly, net income after taxes% 0inally, the exhibits determine cash flow from operations by adding bac* financial boo* accounting and deferred taxes, both of which are non-cash charges !he resulting cash flow from operations is correct !his is made more confusing by the fact that, contrary to most investment opportunities, deferred taxes are negative every year, ma*ing current taxes paid higher than provision for taxes !his also means that the adding bac* of deferred taxes actually reduces cash flow from operations 6ote, too, there is a little circularity going on here because the value of MW and the level of 11;& expenses depend on one another !he authors of the exhibits have sidestepped this problem by basing depreciation on a ballpar* number for the value of the business With more information about the depreciation methods employed, we could eliminate this circularity @ere, we must accept the $probably modest% error involved !axes &s /ust noted the correct tax figure is current tax, and the exhibits arrive at this figure by first subtracting total income taxes, and then adding deferred taxes bac* !his is part of the same 11;& A taxes story &nd in con/unction with the treatment of  these other items, the treatment of 6on-cash charges is correct & terminal value estimate is clearly necessary &nd with a wasting asset, the approach ta*en appears appropriate We might as* if the terminal value includes estimated values of remaining assets, including land, when the reserves expire We might also as* why a "8B discount rate was applied without explanation or /ustification My calculations below

suggest this discount rate might be a bit on the high side, but not far  from the mar* 0inancial boo* 11;& 6on-cash charges !erminal value

= $"# points% Page  of the case contains the following statement, @ence, production and cash flow forecasts for probable reserves often had to be ris*-weighted based on available data and historical experience in comparable fields, to arrive at an estimate that reflected their expected value What do you thin* it means to ris*-weight cash flows( @ere's my interpretation !he correct free cash flow to use in discounted cash flow valuation is the annual expected free cash flow When the annual distribution of free cash flows is symmetric, the expected free cash flow equals the most li*ely free cash flow &bsent a symmetric distribution, this is no longer true and it becomes necessary to weight the outcomes by their probability of occurrence to calculate the expected value !he cash flows from the less certain reserves are li*ely to be asymmetric because there is a meaningful chance that future energy prices will ma*e it uneconomic to exploit the reserves @ere's an example !here are three possible outcomesD E"##, E#, and -E# with probabilities of .#B, #B, and 8#B, respectively !he most li*ely outcome is E#, but the expected outcome is E8# $.xE"## F x E# F 8x-E#% !he correct number for valuation purposes is E8#  $8# points% &ssuming &pache will borrow up to the #B ceiling mentioned on page 9 of the case to finance any acquisition of MW Petroleum, execute a discounted cash flow valuation of all of the MW reserves described in )xhibits 8-9 $Please assume the #B ceiling applies to proved developed reserves% !he easiest way to value MW Petroleum is via &d/usted Present 7alue &s always, a W&CC valuation or an equity valuation are theoretically possible, but quite difficult to apply !o implement a W&CC valuation, we need to estimate &pache's W&CC at its postacquisition capital structure !his is difficult because we need to *now the post-acquisition mar*et value of &pache's equity, which presumes we *now the mar*et value of MW Petroleum A the precise value we see* to estimate in the first place We can get around this by solving for the W&CC and the mar*et value of MW Petroleum simultaneously, but this is not easy & second problem is that because MW Petroleum consists of wasting assets, the amount of debt it can support each year in the future will decline, meaning that a different capital structure and a different W&CC exists each year in the future  &gain, we can handle this problem mathematically, but it isn't easy 0inally, of course, &pache's W&CC will not be the appropriate discount

rate if we believe MW's assets are safer or ris*ier than &pache's existing assets &n equity valuation faces the same problems on steroids because the cost of equity capital is much more sensitive to changes in capital structure than the W&CC is Moreover, because we ultimately want the enterprise value of MW, not the equity value, estimating the equity value needlessly complicates the valuation !o implement an &P7 valuation, we need to do two things 0irst, estimate the all-equity value of MW by discounting the free cash flows in )xhibit 9 by a suitable all-equity cost of capital &nd second, estimate the present value of the interest tax shields associated with use of debt to finance the company 2tep two involves estimating MW's debt capacity, deciding how this capacity changes over time, and finding the present value of the resulting interest tax shields at an appropriate discount rate !he value of MW is the sum of its all equity value and the present value of the interest tax shields

 &ll-equity cost of capital Gsing the C&PM, He  ig FJ 3p, where He is the all-equity cost of capital, ig is a ris*free interest rate, J is MW's asset beta, or its unlevered beta, and 3p is a mar*et ris* premium 4ecause this is a "-year asset, I chose to use the "#-year !reasury rate of :#8B !he 8#year rate of :.=B is also plausible, as is the 8#day rate of >.B -- although my strong preference is for one of the longer-term rates given that we are valuing a long-term asset )xhibit . provides &pache's asset beta and the mean asset beta of six independent energy companies including &pache I prefer the mean asset beta because I want an industry beta, not &pache's, and because I *now for statistical reasons that the average of several observations should a more accurate estimate of the industry beta than a single observation !he mean beta is #>= $!his might appear low but remember that beta captures systematic ris*, and much of the ris* in energy companies is unsystematic% My preference for 3p is the historical arithmetic excess return on common stoc*s relative to government bonds, or about 9B &n historical geometric excess return of about  percent is also defensible $If you want to follow 4realey and Myers and use a short-term ris*less rate of interest and an arithmetic excess return on stoc*s over short-term government bonds, a ris* premium of about :B is also acceptable% Combining these numbers, my estimate of the all-equity cost of capital is :#8B F #>=x9B  ".B Gsing a B mar*et ris* premium, the rate is :#8B F #>=xB  "">B !he all-equity value of MW Petroleum !he present value of the free cash flows in )xhibit 9 $lines "< and .#% discounted at ".B equals E=:: million $!he corresponding figure discounted at "">B is E".8 million% 7alue of interest tax shields 4an*s will lend up to #B of the value of proved developed reserves !he present value of the free cash flows from proved developed reserves appearing in )xhibit 8, discounted at ".B is E8B is E=#:" million% @alf this amount is E"" million &pache's borrowing rate on MW acquisition debt is uncertain !he company is presently 4a8 rated, which is equivalent to 44, but it will be pushing the envelope on MW financing, and the last paragraph of the case mentions 4-rated debt I will assume a rate equal to the average of 44 and 4 as shown in )xhibit "# for 0eb : F :#:: >9>: M E !he estimate is most li*ely biased low as the initial debt value is fairly low ?ne reason is due to the assumption that additional assets are options and cash flow is mostly deriving from further exploration decisions ¬her reason is the method chose to calculate the P7 tax shield !o find the P7 tax shield, the pro/ected tax expenses was used, calculated the tax shield for each year, and discounted the tax shield with cost of debt !he mar*et premium could be a source of bias as

well &s the mar*et premium increases, &P7 estimate tend to be lower  than pro/ected above !he MW assets can be considered as a portfolio containing assets in place and real options !he Proved developed 3eserves is considered to be the assets in place !he rest of the reserves li*e proved undeveloped reserves $as it needs 8M investment to bring this reserve in to production and management can always chose to produce or not to%, probable reserves, possible reserves are considered to be options !here are . M worth other opportunities, and this cash flow is mainly derived from further exploration &gain this can be considered as an option because if the management doesn't chose to ta*e this option, the stream of cash flow simply won't exist !hese options are similar to call options and 4lac* ; 2choles model can be used to find out the values of these real options !hese real options estimated are generally more than the &P7 estimates as it accounts for the cash flows that can arise from exercising a particular  option @owever if we do a sensitivity test, we could see some instances the real option pro/ections are falling, depending on the interest rates, volatility etc 3eal options 6P7  6P7 Proved 1eveloped 3eserve F 6P7 $3eal ?ptions% 6P7 Proved 1eveloped 3eserve Proved undeveloped reserve Incorporating Capex $"88%F"9  =. ?ption is valid for -9 years &ssuming average option duration of > years  &ssuming 7olatility U # $Page > Gnder 3is*s price deviations were nearly #B%

2  :8", R  =>, 3is* free rate :#8, d"  "=>, d.  #.9"% x #>#9"=  >#=> 6P7 Probable 3esrves 2 9=#, R 89, r  :#8B, d"  ">#""===>9#:  >< 6P7 Possible 3eserves 2 :, R 8..", 6$d"%  #:8":, 6$d.%  #8"