An oil and gas company acquired the mineral rights to a project 2 years ago for

Question

An oil and gas company acquired the mineral rights to a project 2 years ago
for a cost of $2 million dollars. Last year the company spent $0.4 million
on geological and geophysical (G&G) expenditures. Today (time zero), the
company wants you to analyze whether it is better economically to sell the
rights to the property for $4.0 million cash now (at time zero), or whether
it would be better to keep the property and develop using one of two drilling
development scenarios for which projected before-tax cash flows are given on
the following time diagrams. All dollar values are in millions of dollars.
-2.0 -0.4 -12.5 8.0 5.0 4.0 3.0 3.0
A) _________________________________________
-2 -1 0 1 2 3 4 5


-2.0 -0.4 -9.0 7.0 4.0 2.5 2.5 0.0
B) _____________________________________
-2 -1 0 1 2 3 4 5


Use ROR analysis to determine whether it is better to sell the rights to the
property today (time zero), or begin development using either the “A” or “B”
scenarios. Assume the investor is seeking a nominal before-tax minimum ROR of
10%. Verify your ROR findings with NPV and PVR analyses. Then, compare the
three options if the minimum ROR is raised to 20% reflecting the hurdle rate
the company is currently imposing on projects.

Explanation / Answer

it is not nice to sell the property today for 4 million as the NPV under both the other options give a higher NPV. the solution is attached below

Option A

Option B

Option A - whern ROI is 20%

Option B - whern ROI is 20%

In this scenerio it is better to sell today for 4 million

0 1 2 3 4 5 Cash flow -12.5 8 5 4 3 3 Present value 1 0.909091 0.826446 0.751315 0.683013 0.620921 Dicount
7.272727 4.132231 3.005259 2.04904 1.862764 NPV




5.822022

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