MW Petroleum Corporation: Finance - Case Study Example

MW Petroleum Corporation (A) Part a) Amoco’s strategy is to rationalize its operations by shedding assets that arenot contributing significantly to the company’s gross margin. This is reasonable as both the direct costs and overhead cots are high. The company is very large and the management appears unable to manage the operations as they are right now. Apache on the other hand is seeking to grow. This is a good opportunity for the company to do so. This transaction would be beneficial to Apache the portion of MW Petroleum that Apache is considering is located in the same general area where the company currently operates and so consolidation will further reduce costs. This should allow for increased economies of scale in the form of reduced direct operating costs and even more so overhead costs for Apache. It is cheaper for Apache to buy an existing business as it has been doing rather than carry out exploratory drilling. This acquisition will also allow the company to diversify geographically its portfolio of assets which is important when the riskiness of the operations is considered. This diversification will somewhat help to stabilize Apache’s earnings even though both gas and oil prices are highly volatile. The acquisition of Amoco will also enhance Apache’s standing among US independents and lead to even further acquisition opportunities. The company is considering further growth opportunities in the future and this represents a stepping stone that will allow Apache some amount of bargaining power and would therefore put the company in a better position to compete with other companies. It is reasonable to expect that the MV properties are more valuable to Apache than to Amoco because Apache will benefit from synergies and rationalization of expenses. Table 2 below shows the present value of the aggregate overheads that Apache could reduce substantially if the acquisition takes place. Amoco would be better off if it had cash in hand which the company could invest in more profitable ventures. Currently, the properties are not contributing substantially if any at all to the company’s overheads. Part 1 (b) The sources of value that most plausibly account for the difference between buyer and seller are: The exclusion of fields in Michigan and the Gulf of Mexico; Expected synergies; Other opportunities mentioned; and The beta value that was used. Exclusion of Fields in Michigan and the Gulf of Mexico Apache was only interested in fields containing approximately 78% of MW’s proved developed reserves and 75% of the Proved undeveloped reserves. These account for approximately $120 million of the difference. No details were given of the percentage of the probable and possible reserves that would be included in the fields in Michigan and the Gulf of Mexico. However, these could be substantial. Assuming that these fields are in the same proportion as the proved undeveloped reserves then the total value would be approximately $906 million. This is 294 million less then the $1.2 billion that Amoco indicated that the properties were worth. See APV Calculations in the Appendix. Table 1 Reserves Total (MMBOE) Proportion included in Purchase Value included in APV Total Value Proved Developed Reserves 155.2 78.22% 121.4 247,750,571.44 316,728,901.87             Proved Undeveloped Reserves 25.6 75% 19.2 151,257,604.86 201,676,806.48 Sub Total       399,008,176.30 518,405,708.35             Probable Reserves   75%   145,575,867.21 194,101,156.28             Possible Reserves   75%   145,125,191.13 193,500,254.84             Total       689,709,234.64 906,007,119.47 Synergies The synergies can be quantified as some overheads would be much reduced as well as some direct operating costs. The table below shows the present value of the projected aggregate overhead expenses. Apache is expected to save a substantial portion of this approximately $201 million. Table 2 Year Aggregate Overheads PV Factor (13%) PV Cash Flow 1 36.6 0.885 32.39 2 38.7 0.7831 30.31 3 36.3 0.6931 25.16 4 33.6 0.6133 20.61 5 31 0.5428 16.83 6 28.8 0.4803 13.83 7 29.2 0.4251 12.41 8 29.3 0.3762 11.02 9 27.9 0.3329 9.29 10 26.3 0.2946 7.75 11 23.2 0.2607 6.05 12 21.4 0.2307 4.94 13 20.1 0.2042 4.10 14 19.1 0.1807 3.45 15 17.8 0.1599 2.85 Total 419.3   200.98 Other opportunities Other opportunities mentioned in the case amounted to $25 million which is expected to be accepted by Apache. Apache could also shorten the life of the projects where possible. This would yield higher APV’s than calculated. The beta value used in the calculation was 0.82. The mean beta value estimated by Morgan Stanley for independent companies including Apache was 0.64. Substituting this beta value into the cost of equity calculation would yield a rate of 11.87%, 1.12% lower than the 12.99% used in the APV calculation. Part 2 (a) If a sale goes through Apache would exercise each of the various options by waiting until year 5 to exploit the proved undeveloped reserves, the probable reserves and the possible reserves. This will allow the company to generate enough cash to carry out its operations. This would place the company in a more favorable light to get the loan that it requires. Part 2 (b) Apache should wait until the conditions are right before exercising its options. This would ideally be when oil prices are rising. However, all things being equal the company should start with the proved undeveloped reserves first in year 5 because it involves the least capital expenditure, followed by the probable reserves in year 6 which involves much less expenditure than the possible reserves. The possible reserves should be left for last because the expenditure is very high in year 7. Leaving it until last will result in a higher aggregate APV for Apache. Reference Wall, B.D. (1994). MV Petroleum Corporation (A). Boston, MA: Harvard Business School Publishing Appendix Cost of Equity Calculation Riskless Rate (10-Year U.S. Govt Bond) 8.03% Beta 0.82 Market Risk Premium 6% Cost of Equity 12.9500% Reserve Type ATV Proved Developed $247,750,571.44 Proved Undeveloped $151,257,604.86 Probable $145,575,867.21 Possible $145,125,191.13 TOTAL $689,709,234.64 Proved Developed Reserves Free Cash Flows (FCFs) $701,600,000.00 Terminal Value (TV) $92,100,000.00 Cumulative Cash Flow $793,700,000.00     Present Value (FCFs) $112,926,547.72 Present Value (TV) $14,824,023.72 Debt $300,000,000.00 Tax Rate 40% APV $247,750,571.44 Proved Undeveloped Reserves Free Cash Flows (FCFs) $126,400,000.00 Terminal Value (TV) $67,800,000.00 Cumulative Cash Flow $194,200,000.00     Present Value (FCFs) $20,344,805.63 Present Value (TV) $10,912,799.22 Debt $300,000,000.00 Tax Rate 40% APV $151,257,604.86 Probable Reserves Free Cash Flows (FCFs) $107,900,000.00 Terminal Value (TV) $51,000,000.00 Cumulative Cash Flow $158,900,000.00     Present Value (FCFs) $17,367,124.43 Present Value (TV) $8,208,742.78 Debt $300,000,000.00 Tax Rate 40% APV $145,575,867.21 Possible Reserves Free Cash Flows (FCFs) $83,800,000.00 Terminal Value (TV) $72,300,000.00 Cumulative Cash Flow $156,100,000.00     Present Value (FCFs) $13,488,091.08 Present Value (TV) $11,637,100.06 Debt $300,000,000.00 Tax Rate 40% APV $145,125,191.13 TOTAL APV $689,709,234.64 Read More