Question

Natural Resources Co. is an oil and gas exploration company that is currently operating two active oil fields with a market value of $200 million each. The company has $500 million in debt coming due at the end of the year. A large oil company has offered Natural Resources Co. a highly speculative, but potentially very valuable, oil and gas lease in exchange for one of their active oil fields. If Natural Resources Co. accepts the trade, there is a 10% chance that it will discover a major new oil field that would be worth $1 billion, a 15% that it will discover a productive oil field that would be worth $600 million, and a 75% chance that it will not discover oil at all.

a) What is the overall expected payoff to Natural Resources Co. from the speculative oil lease deal?
b) What are the payoffs to the debt and equity holders with and without the speculative oil lease deal?
c) Which alternative would equity holders prefer? Which alternative would debt holders prefer? What is the economic term that describes this situation? Discuss the problem based on what you learn from the course.

Answer 1

The overall expected payoff to Natural Resources Co. from the speculative oil lease deal can be calculated using probabilities and values. Equity holders would prefer the alternative with the speculative oil lease deal, while debt holders would prefer the alternative without it. This situation can be described as risk versus reward.

Step-by-step explanation:

The overall expected payoff to Natural Resources Co. from the speculative oil lease deal can be calculated by multiplying the probability of each outcome by its corresponding value and summing the results. The expected payoff is determined by multiplying the probability of discovering a major new oil field ($1 billion) by 10% and adding it to the product of the probability of discovering a productive oil field ($600 million) by 15%, and finally adding the product of the probability of not discovering oil by 75%.

The payoffs to the debt and equity holders with and without the speculative oil lease deal depend on the outcome of the lease. Without the lease deal, the payoffs remain at $200 million each for the active oil fields, which is the market value. With the lease deal, the payoff for discovering a major new oil field is $1 billion, and for a productive oil field, it is $600 million.

Equity holders would prefer the alternative with the speculative oil lease deal since it offers the potential for higher payoffs. Debt holders, on the other hand, would prefer the alternative without the speculative oil lease deal as it guarantees the market value payoffs and reduces risk.

The economic term that describes this situation is risk versus reward. By accepting the highly speculative lease deal, Natural Resources Co. is taking on the risk of not discovering oil, but also has the opportunity for higher rewards if oil is discovered.