An oil company has a project which requires an investment of $400 million with p
ID: 2730692 • Letter: A
Question
An oil company has a project which requires an investment of $400 million with payoffs depending on the oil price, of $800 million (state 1: high oil price) or $200 million (state 2: low oil price) the following year. Each of these outcomes occurs with equal probability (of .5). Disregard interest rates and assume the discount rate equals 0.
a) Should the company undertake the project?
b) The company seeks external debt financing for the project. What is the maximum amount of debt financing they can obtain assuming that lenders want to be sure of being repaid?
c) Assume that the company engages in an oil price hedging program which provides a positive payoff of $300 million in state 2:low oil price, and a negative payoff of -$300 million in state 1: high oil price. How much will lenders be willing to lend the company assuming that the lenders want to be sure of being repaid? Assume the hedging program is costless.
Explanation / Answer
a. Probable cash inlfows = 800 x 0.50 + 200 x 0.50 = $500 million
Cash ouflows = $400 million
SInce the cash inflows are greater than outflows, the company should undertake the project.
b. The maximum amount of debt financing is equal to Probable cash inflows from the project i.e. $500 million.
c. Probable cash inflows = 300 x 0.50 + (-300 x 0.50) = Nil
The lenders won't be willing to lend any amount to the company in this case.