Question 1 (10 points): Explain why the capital expenditure build-up in the unco

Question

Question 1 (10 points): Explain why the capital expenditure build-up in the unconventional oil and gas sector was heavily financed by debt.

Question 2 (10 points): A firm issues a single level coupon bond with a face value of $1,000 and a coupon rate of 15%. Coupon payments are made annually. The firm's EBITDA is $750 per year. Calculate the interest coverage ratio for this firm.

Question 3: A power plant that produces emissions of sulfur dioxide (SO2). Annual emissions are 1,000 tons per year in perpetuity and it currently faces an emissions tax of $20 per ton of SO2. The power plant can install a scrubber with a capital cost of $50,000. If it uses the scrubber, it incurs a one-time cost of $250,000 and the plant will not emit any SO2 for the remainder of its operational life. The plant faces a discount rate of 10%. There is no marginal cost to using the scrubber. We can thus view the scrubber as an option to control SO2 emissions in the future.

(A, 10 points): Should the power plant install the scrubber and commit to using it?

(B, 20 points): There is a 50% probability that the emissions price will increase to $35 per ton next year. Calculate the value of the option to control SO2 pollution. Should the power plant install the scrubber?

Explanation / Answer

solution to the question 2 given above:

Interest Coverage Ratio = EBIT / Interest

= 750 / 150

= 5 times.

Working note: Interest = Face Value * coupon rate /100

= 1000 * 15 /100

= 150.

Solution to question 1:

Many oil companies shrank their D/E ratios during the mid-2000s on the back of ever-rising oil prices. Higher profit margins allowed companies to pay off debt and rely less heavily on debt for future financing. Starting around 2008-2009, oil prices dropped dramatically. There were three main reasons: fracking allowed companies to reach new oil reserves in an economical way; oil and gas shale production exploded, particularly in North America; and a global recession put downward pressure on commodity prices.

Profit margins and cash flow fell for many oil and gas producers. Many turned to debt financing as a stop-gap; the idea was to keep production flowing through low-interest debt until prices rebounded. This, in turn, pushed up D/E ratios across the industry.

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