Simulation

Topics: Taxation, Taxation in the United States, Net present value Pages: 10 (3434 words) Published: April 27, 2011
The Bailey Prospect[1]

It is Thursday, May 18, 1988. Your assignment is to help Sprigg Lane Natural Resources evaluate the risks associated with a potential investment in the "Bailey Prospect," a natural gas opportunity in Doddridge County, West Virginia. Your colleague, Lisa Weatherford has done a thorough base-case analysis and constructed a spreadsheet model that you can use in your analysis. You and Lisa are financial analysts at Sprigg Lane Investment Corporation.

Background

Sprigg Lane Natural Resources (SLNR) is a new division of the Sprigg Lane Investment Corporation (SLIC) and was formed in 1987. SLIC is a privately held investment corporation founded in 1961. It had become a diversified company consisting of a total of 9 subsidiaries. The oldest three were in the home products business: a Virginia-based brass giftware company, an outdoor lantern company based in Maine, and an antique reproduction furniture company in Maryland. A second group of four subsidiaries formed in the 1970's was focused on research in the fields of consumer product marketing, computer software, tax research, and investment financial analysis. Hoping to capitalize on their tax and investment expertise, they recently formed Sprigg Lane Development Corporation and Sprigg Lane Natural Resources, which were involved in real estate development natural resource exploration, respectively. Sprigg Lane employed a total of 525 people and had revenues of $30 million in 1987.

Sprigg Lane Natural Resources was formed to pursue natural resource exploration because SLIC management felt that favorable tax laws provided them opportunities to achieve significant profits in this arena. Their primary goal was to find and produce natural gas from shale, to capture the so-called "Section 29" tax credits associated with such gas. Congress passed this tax credit in 1978 as part of the Natural Gas Policy Act in order to stimulate drilling for natural gas found in shale.

Although natural gas exploration was clearly riskier than their other investments, SLIC felt the risks could be managed by drilling only sites that were surrounded on three or four sides by existing wells. To date, SLNR had drilled four wells. It wasn't difficult operationally to drill the wells, but it was challenging to find enough high-quality investment opportunities. In the first five months of production, one of the wells had already paid back 52 percent of its initial investment -- well ahead of the target payout. The other wells were also doing quite well and all were on schedule for meeting their target return on investment. SLNR hopes to drill 20 more wells in 1988.

SLNR acted as the managing general partner in the gas-drilling ventures they formed. This gave SLNR full responsibility for choosing the sites and managing the well if gas was found. SLNR would retain about 25 percent ownership and sell the rest to several general partners. As managing general partner, SLNR was responsible for hiring a general contractor who would do the drilling. SLNR's geologist, Brad Thomas, would determine whether there was enough gas to make it worth completing the well. If he decided to go ahead, the general contractor would be in charge of the day-to-day operations of the well. SLNR had entered into a joint venture with Excel Energy of Bridgeport, West Virginia, in which it was agreed that Excel would act as the general contractor for all of SLNR's wells in West Virginia. Excel also agreed to take a small ownership interest in each of these wells.

The Bailey Prospect: Base Case Analysis

Exhibit 1 is a copy of the spreadsheet developed by Lisa Weatherford to analyze the Bailey Prospect. The Bailey Prospect is surrounded by four producing wells from the target gas formation. Thus, SLNR was pretty confident that they would hit the gas formation, but they were mindful that there is always a possibility that due to geological anomalies (e.g., drilling into a...
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