Section C

Question C1
(i) Relevant Cash Flow.
All cash flow of committed exploration and appraisal that had been spent prior to 2008 is irrelevant to the decision at hand and
hence should be ignored as sunk costs. This includes all cash flow in 2005, 2006 and 2007.
Screening Criteria.
Cash flow given is in mod terms and hence we ought to discount using nominal interest rate. Given the inflation rate is 3% and
the real hurdle rate of IPE and its partners is 12.62% then the nominal interest rate is 16%. NPV is computed at discount rate of 16%
NPV @ 16% as of 2008 as base year
Ardenden £53.70 millions
Beshum £35.48 millions
Gilead £10.70 millions
Since all three NPVs are positive all three prospects are therefore economically profitable given the assumptions.

(ii) If financing is limited for partners it may be beneficial to rank the investments on the basis of economic efficiency as well, i.e., NPVI.
IRR reflects similar characteristics but is not recommended because of the difference in timing and size of cash flows across projects,
as well as the problem associated with different discount rates and the negative abandonment expenses.
Using the same 16% (nominal rate) criterion as before, the following information is derived.
` NPV[0.16] MCO[0.16] NPVI
Ardenden £53.70 m 83.04 0.65
Beshum £35.48 m 55.59 0.64
Gilead £10.70 m 54.40 0.20
According to this criterion Ardenden, with the largest reserves, is only marginally better than Beshum while Gilead is clearly inferior.

(iii) Sale price is indicated by NPV. 33.33% equity share is thus .3333 of (53.7 + 35.48 + 10.7) = £33.29 million. Different views arise
from having different inputs to the calculation of NPVs. Some of these may relate to reservoir performance and hence associated
costs, engineering costs, facilities costs and operating expenditure. Others may relate to tax positions, different opinions about the
appropriateness of the hurdle rate. Some variables obviously are external and hence estimates may differ, such as projections of gas
price or outlook on taxation regime.
Ardenden Beshum Gilead

NCF DNCF CDNCF NCF DNCF CDNCF NCF DNCF time discount factor
-1 -1 -1
-15 -5 -10 r= 0.16
-5 -5 -5
-5 -5 -5 0 1
- - - - - -
-75 64.65517241 69.65517241 -30 25.86206897 25.86206897 -45 38.79310345 38.79310345 1 0.862068966
- - - - - -
-18 13.37693222 83.03210464 -40 29.72651605 55.58858502 -21 15.60642093 54.39952438 2 0.743162901
- - -
48 30.75156833 52.28053631 33 21.14170323 34.44688179 23 14.73512649 39.66439788 3 0.640657674
- - -
61 33.68975697 18.59077934 41 22.64393501 11.80294678 25 13.80727745 25.85712044 4 0.552291098
-
53 25.23398982 6.64321048 34 16.18784252 4.384895746 26 12.3789384 13.47818204 5 0.476113015
-
33 13.5445944 20.18780488 33 13.5445944 17.92949015 21 8.619287348 4.858894688 6 0.410442255
34 12.03020402 32.2180089 27 9.553397307 27.48288746 19 6.722761068 1.863866379 7 0.35382953
29 8.845738247 41.06374715 20 6.100509136 33.58339659 16 4.880407309 6.744273688 8 0.305025457
24 6.31087152 47.37461867 10 2.6295298 36.21292639 15 3.9442947 10.68856839 9 0.26295298
19 4.306988465 51.68160713 5 1.133418017 37.34634441 10 2.266836034 12.95540442 10 0.226683603
- -
13 2.540419694 54.22202683 -13 2.540419694 34.80592472 -15 2.931253493 10.02415093 11 0.1954169
8 1.347702755 55.56972958 4 0.673851378 35.47977609 4 0.673851378 10.69800231 12 0.168462844
0 0 55.56972958 0 0 13 0.14522659
-
-21 2.629102061 52.94062752 0 0 14 0.125195336
7 0.755489098 53.69611662 0 0 15 0.107927014

NPV 53.69611662 0.646691022 35.47977609 0.638256507 10.69800231 0.196656174

NPVI NPVI NPVI
Question C3
(i)

Dry 0 -D
(1-p)

pR-D

Drill -D Oil R R-D

p
Drill if
(p+0.15)C <
pR-D

Farm out Dry

1-p-0.15 0 0

(p+0.15)C

Oil C C
P+0.15
40%

EMV(Drilling) = p(R-D) + (1-p)D = pR-D

EMV(farming out) = (p+0.15)C
(ii) If p=0.3 In order to farm out 0.45C must be > 9-5, or C must be greater than $8.9 million
If p=0.4 In order to farm out 0.55C must be > 12-5, or C must be greater than $12.73 million
If p=0.6 In order to farm out 0.75C must be > 18-5, or C must be greater than $17.33 million
It is therefore obvious that higher probabilities of success in finding oil can sustain higher levels of carried interest that KO can
negotiate with MD.

(iii) If p = 30% and R = $30 then for drilling to be more attractive than farming out to KO the cost of drilling D and the level of carried
interest must be related by 0.45C <9-D or the cost of drilling D must be < 9 - 0.45C (or $9 million less 45% of the level of carried
interest). These kind of relationships can be instrumental in negotiations.