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Company Background

The company is headquartered in London, England. By market capitalization, it is the 6th largest
energy company. It is also the 6th largest oil and gas company all over the globe. The company
is involved in almost all the major operations in oil and gas industry. The operations include
petrochemicals, refining, trading, power generation, etc.

BP currently operates in around 80 countries. It produces around 3.2 million barrels per day. It is
one of the largest producers of oil and gas industry in the whole world. The company has around
17,000 service stations spread all over the world. The company has some of the stake in the
worlds largest traded oil and gas company, Rosneft. British Petroleum is also listed on the
London Stock Exchange. There are also the secondary listings of the company as well in
Frankfurt stock.

The origin of the company dates back to 1909. It was originally the founding of the Anglo-
Persian Oil Company. By 1935, it became the Burmah Oil Company and it was established to
exploit the discoveries of oil in Iran. The company became British Petroleum in the year 1954.
BP was the first company to strike oil in the North Sea.

The company has also been involved in some of the major environmental incidents in the history.
One of the major incidents was the Texas City Refinery explosion in the year 2005. Another
incident was the Deepwater Horizon oil spill in the year 2010. It was the largest incident in
which the oil was released into the marine water. It resulted in many environmental
consequences later on. The company has around 83, 900 employees as of 2013. There are two
main business units in the company. One segment is called as Upstream and the other one is
called Downstream. The major operations of the company operate in many countries across the
globe, including Africa, Asia, Australia, Europe, and North& South America.

The major business segments of the company include oil and natural gas, oil refining and
marketing, low carbon energy, etc. The company adopted many major branding techniques, but
suffered a serious negative public image after one of the largest environmental incidents
occurred due to the giant.

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PESTLE Analysis of Azerbaijan

Political
It gained its jurisdiction from Russia in 1991. In the constitution of the nation executive power
consists of upper, central and local power bodies. The supreme power is held by president of the
Azerbaijan and the president of the country is elected through common and direct voting.
The president of Azerbaijan is IIHAM ALIYE. The President has the power to sign the law
introduce to him. The major parties of Azerbaijan are New Azerbaijan party, National Revival
Movement Party, Equality Party, Azerbaijan popular party, Motherland Democratic party. The
current party which is in power New Azerbaijan party.
The New Azerbaijan Party formed on 18th December 18,1992 by the previous president
HeydarAliyev. Its now ruled by his son IIHAM ALIYE. The supreme court of Azerbaijan is
supreme judicial body on civil, criminal and other related cases.

Economical
The currency of Azerbaijan is Azerbaijani manat. Its per capita GDP is 7,811.79 USD (2013) by
world bank, the growth rate is 5.8% annual change. Its GDP grew 41.7% in the 20 07, which is
largest of any country worldwide. The BAKU-TBILISI-CEYHAN Pipeline played major role in
the growth of economy. These large oil reserves are the crucial part of the growing economy.
The oil and gas, machinery, cotton and foodstuffs exported by Azerbaijan and the countries it
export are Italy, Germany, Indonesia, France and Czech Republic. The import things which
Azerbaijan imported are machinery and equipment, oil products, foodstuffs, metals, chemicals
and the countries it imported are Russia, Turkey, UK, Germany and Italy.
The sectors of economy are Agriculture, Manufacturing, Services (Financial and
Telecommunication Services), and Tourism.
The conversion of us dollar is 1 Azerbaijan Manat = .56 US dollar

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Social
The ethnic group of Azerbaijan is known as Azerbaijani or AZERIS basically refers to the
Turkic people and it is also the neighboring country of the nation. They historically called
themselves as Muslims, Turks, Persian or Ajams (by Kurds). The AZERIS are more closely and
influenced to neighboring people rather than to Central Asians.
The official language of Azerbaijan is AZERBAIJANI.
Around thirteen languages are spoken in Azerbaijan, and are used in everyday communication.
But Azeri is used in all spheres of public life.
PULOV (steamed rice) garnished with apricots and raisins is famous dish at ritual celebrations.

Technology
As per the technology the major economy income depends on and natural gas, petrochemicals,
chemicals, oil refining, ferrous and nonferrous metallurgy, building materials, and electro
technical equipment. Nearly 500 new private institutions in IT (Information Technology) sectors
were developed. During 2010 incomes of IT, post and information sectors as compared with
previous year reached 1 milliard 23,200,2000manats increasing up to 32.1 per cent.
The steps taken in technology sector by nation are computerized of schools, virtual world for the
youth and groom their skills for IT sector. With the growing of interest of ICT (information
communication Technology) sector, Azerbaijan hosted BakuTel on 3-6 nov 2010.
The Ministry of Communication and Information Technology of Azerbaijan proposed various
digital projects which are crucial and feasible projects. Some are transition to digital TV, the
modernization of postal services to incorporate the provision of banking services, and the
modernization of telecommunication infrastructure on the basis of next generation networks.

Legal

Constitution, orders acts accepted by referendum, orders and normative acts of central executive
power bodies are the parts of legislative system of Azerbaijan. The executive powers are in the
hand of President.
The citizen of Azerbaijan having age 35 years age or more with 10years of permanent residence
and not having citizenship of other country has the right of voting in electing of president.

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The president establishes cabinet ministers for the implementation of executive powers.
The judicial powers are implemented by law courts. The judges dont have any influence they
are independent and they cant be replaced during the term of their authority.

Judges of Constitutional Court of the Azerbaijan Republic are appointed by MilliMajlis


(legislative branch of government in Azerbaijan) of the Azerbaijan Republic on recommendation
by the President of the Azerbaijan Republic.

Environmental

As we know Azerbaijan is known for their heavy industries of oil and petroleum and they are
major contributor for the growth of economy but these causes severe problem in terms of
pollution. The pollution graph has been increasing from day to day because of heavy industries
and agriculture, one of the side effect is the exploitation of oil reserves of Baku which is capital
of Azerbaijan.

There are other various ecological problems of Azerbaijan such as


The water pollution because introduction of contaminated water, including transnational
pollution. Air pollution from industrial plants and transport vehicles. Decline in biological
diversity and also decline in forest reserves and fauna, especially fish results.

To overcome this situation environmental protection goal, a number of important laws, all of
which conform to European law requirements, have been developed and approved in order to
improve the ecological situation in the country.

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Porters 5 Forces Model

Industry Rivalry:

The main rivals of British Petroliam are Exxon, Shell, Total, Gulf Coast, OMP and Petro China.
Product differentiation, economy of scale, fixed and variable cost are the main factors in which
the companies compete with each other. In this century a major prediction by the scientists is that
within 2050 there may be a high chance that the large number of oil well will be dried up. And
the companies are making the chance to grab the fare share in the market. As a result a number
of big companies are moving towards merging with other companies. In this situation BP is
running towards to merge with small companies. When it comes to renewable resources,
companies are in great competition to stay in the market.

Threat of new entrants:

Although the industry is very attractive in this region of the world, it is very difficult to enter and
run the business. The reason is the variable cost and the new tax reformation in 2016. Moreover,
operating tax is 4% in Baku where as it is 2%outside Baku. Another reason is BP is a well-
established company in Azerbaijan and it has been running the operation successfully from 24
years.

Threat of substitutes:

New science and technology is moving towards non-renewable sources of energy. As a result, in
future there may be a significant chance to emerge renewable energy industries like, biofuel
industry, solar industry. But these developments are still under research level. So it can be said
that the threat is still moderate.

Bargaining power of suppliers:

BP has edge over other companies in case of bargaining with their suppliers as the suppliers are
not willing to lose such business. Moreover, the country itself is also the oil supplier so it has
bargaining power over buyers. On the other hand, counties like Saudi Arabia, Kuwait, and Iran
also has large number of wells. As a result they have this luxury to set their convenient oil price.

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Bargaining power of buyers:

The price of oil is depended on the global price. The countries those have high political power
have a high bargaining power over the supplier. In this case Azerbaijan in not politically strong
country so they must have to be obedient to countries like USA, China, UK, and Russia.

Portes five forces Intensity


Industry Rivalry High
Threat of substitutes Moderate
Threat of new entrants Low
Bargaining power of suppliers Low
Bargaining power of buyers High

SWOT Analysis

Strength:

Azerbaijan lies at the heart of the international transport corridor between Europe and
Asia.
Azerbaijan is growing a highly educated and skilled workforce.
Azerbaijan has substantial hydrocarbon reserves.
The country enjoys favored trade status under an EU Partnership and Cooperation
Agreement.

Weakness:

Chance of oil spells


Limited gas storage
A weak legislative and regulatory framework
The unresolved status of the Caspian Sea with Iran and Turkmenistan.
Uprising inflation. (given in chart 1)
Declining per capita GDP.

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Opportunity:

Increased production of domestic resources (oil and gas).


Expansion of the transit infrastructure.
Increasing volumes of the transit of Central Asian hydrocarbon reserves.

Threats:

Proximity to conflict zones and terrorist threats.


The countrys transformation from an exporter of energy resources into an importer (in
25-30 years)
Pressures on fiscal revenue streams as a result of explicit and implicit subsidies.

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Country Risk Analysis

In this part of our discussion, we are going to make an analysis of the Country Risk of
Azerbaijan based on the ICRG Model. We know that thereare 3 components which creates the
total country risk:

1. Political Risk
2. Economic Risk
3. Financial Risk

Political Risk

In order to derive the total Political Risk, we need to give points to the individual criteria.

Government Stability This is an assessment both of the governments ability to carry out its
declared program(s), and its ability to stay in office. There are 3 subcomponents for this criteria,
they are, Government Unity, Legislative Strength and Popular Support. For Government Unity
we have given 4, Legislative Strength 3 and Popular Support 2. The government of the Republic
of Azerbaijan is organized at the base of principles of separation of power. The Constitution
determines that the executive power is held by the President of the Republic of Azerbaijan, the
legislative power is carried out by the Parliament of the Republic of Azerbaijan - MilliMajlis of
the Republic of Azerbaijan, and the judicial power is held by the independent courts.

Socio Economic Conditions - This is an assessment of the socioeconomic pressures at work in


society that could constrain government action or fuel dissatisfaction. Its subcomponents are
Unemployment, Consumer Confidence and Poverty.For Unemployment we have given 4 points,
Consumer Confidence 3, and Poverty 2. The justification can said such that unemployment is
very low in Azerbaijan and historical data shows that the trend is increasing, consumer
confidence is high as Azerbaijan has always been known for their quality products and finally
poverty, the poverty level is not that high but it has not been completely eradicated.

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Investment Profile This is an assessment of factors affecting the risk to investment that are
not covered by other political, economic and financial risk components. There are 3
subcomponents, Contract Viability, Profits Repatriation and Payment Delays. For Contract
Viability we have given 4, Profit Repatriation 1 and Payment Delays 3.

Internal Conflict This is an assessment of political violence in the country and its actual or
potential impact on governance. The subcomponents are Civil War, Terrorism and Civil
Disorder. For Civil War we have given 2, Terrorism 1 points and Civil Disorder 1 points as well.

External Conflict The external conflict measure is an assessment both of the risk to the
incumbent government from foreign action, ranging from non-violent external pressure to violent
external pressure. The subcomponents are War, Cross-Border Conflict and Foreign Pressures.
For War we have given 3, Cross-Border Conflict 2 and Foreign Pressures 1.

Corruption This is an assessment of corruption within the Political System. For corruption
we have given 1 points. Several reports& historical trends have shown that there is a high level
of corruption in Azerbaijan, thus this is the reason for the low score.

Military in Politics This is an assessment of the degree to which military is involved in


Politics. For Azerbaijan we have given 2 points.

Religious Tensions This is an assessment of the degree to which there are religious tensions
within the country. For Azerbaijan, we have given 3 points for this criteria.

Law and Order This assessment involves the level to which law and order is implemented in
country. For Azerbaijan we have given 3 points for this criteria.

Ethnic Tensions This component is an assessment of the degree of tensions within a country
attributable to racial nationality, or language divisions. For Azerbaijan, we have given 2 points
for this criteria.

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Democratic Accountability This is a measure of how responsive the government is to its
people, on the basis that the less responsive it is, the more likely it is that the government will
fall, peacefully in democratic society, but possibly violently in a non-democratic one. For this
criteria, we have given Azerbaijan 3 points.

Bureaucracy Quality It is a measure of the institutional strength and quality of bureaucracy.


For Azerbaijan, we have given 2 points for this criteria.

Political risk components

Components Points Maximum


Government Stability 9 12
Socio Economic Conditions 9 12
Investment Profile 8 12
Internal Conflict 4 12
External Conflict 6 12
Corruption 1 6
Military in Politics 2 6
Religious Tensions 3 6
Law & Order 3 6
Ethnic Tensions 2 6
Democratic Accountability 3 6
Bureaucracy Quality 2 4
Total 52 100

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Economic risk

The overall aim of the Economic Risk Rating is to provide a means of assessing a countrys current
economic strengths and weaknesses. In general terms where its strengths outweigh its weaknesses it will
present a low economic risk and where its weaknesses outweigh its strengths it will present a high
economic risk.
Economical risk components

Criteria Range Points


GDP per head 250+ 5
Real GDP growth 2.5 to 2.9 8
Annual Inflation rate < 2.0 10
Budget Balance as a 2.0 to 2.9 9
Percentage of GDP
Current Account as a 10.0 plus 15
Percentage of GDP
Total 47

Financial risk

Points are awarded to each risk component on a scale from zero up to a pre-set maximum. In general
terms if the points awarded are less than 50% of the total, that component can be considered as very high
risk. If the points are in the 50-60% range it is high risk, in the60%-70% range moderate risk, in the 70-
80% range low risk and in the 80-100% range very low risk. However, this is only a general guideline as
a better rating in other components can compensate for a poor risk rating in one component.

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Financial risk components

Criteria Range Points


Foreign Debt as a Percentage 5.0 to 9.9 9.5
of GDP
Foreign Debt Service as a 5.0 to 8.9 9.5
Percentage of Exports of
Goods and Services
Current Account as a 15.0 to 19.9 14
Percentage of Exports of
Goods and Services
Net International Liquidity as 15 plus 5
Months of Import Cover
Exchange Rate Stability -0.1 to -4.9 10
Total 48

Thus, we can now arrive at the Composite Political, Financial and Economic Risk Rating.
(Azerbaijan) = 0.5*(PR + + )
= 0.5*(52 + 47 + 48)
= 73.5
Finally, we can conclude that Azerbaijan belongs to the low Risk Range as per the ICRG Rating
Model.

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Monte Carlo Simulation

In this part of the report, we are going to discuss about the Monte Carlo Simulation that we have
done for this report. For the simulation we have taken the model that was given in the case, but
we have adjusted the key variables with some growth rates and assumed their probability
distribution for the simulation. Here are the variables that we have simulated and their initial
growth values.

Oil production volume 1000


Projected reservoir size (recoverable barrels) 1000
Azeri crude price 75.00
Natural gas contract price 10.00
Finding and development costs per barrel 9.50
Production & overhead costs per barrel 2.70
Transportation costs per barrel 5.00
Natural gas production 0%
BP project equity 50%
Maintenance capital expenditure, annual 0.5%
Inflation 0%
Profit tax 20%
Max production to capital recovery 50%
Project discount rate 8%
Sales growth 3%
Initial Investment 5178

For Production volume, we have taken the standard Normal Distribution with an initial growth
rate of 800 and Standard Deviation of 1100.

For Crude price, we have taken the Triangular Distribution with a minimum value of 65, likeliest
75.

For Natural gas contract, we decided to take uniform distribution with with location 0 and mean
of 10.

For transpotation cost we decided to take a uniform distribution with a minimum value of 4,
maximum value 6.

For Project discount rate, we decided to take a normal distribution with an initial value of 8%
and standard deviation of 1%.

For Sales Growth, we have taken the standard Normal Distribution with an initial growth rate of
3% and Standard Deviation of 2%.

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For project discounting rate, we have taken the standard Normal Distribution with an initial
growth rate of 8% and Standard Deviation of 1%.

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From the above output, we have arrived at the following information:

The NPV has a Coefficient of Variation of 0.3257 which is an indicator of low risk.
NPV is most sensitive to project discount rate, thus, we need to take that into special
considerationwhen evaluating the project.
IRR has a coefficient of 0.4002, which is satisfactory as that displays low risk as well.
Unlike NPV, IRR is most sensitive to Sales Growth.

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Real Options

A real option is a choice made available with business investment opportunities, referred to as
real because it typically references a tangible assetinstead of financial instrument. Real options
are choices a companys management makes to expand, change or curtail projects based on
changing economic, technological or market conditions. Factoring in real options impacts the
valuation of potential investments, although commonly used valuations, such as net present
value,fail to account for potential benefits provided by real options. In our case of British
Petroleum, we have seen that Samira Bayramli is currently on the verge of making a decision as
to what they should do regarding their project Absheron in Azerbaijan. Here is the Real Option,
there is a possibility that British Petroleum will enter an extended Joint-Venture with Azerbaijan
and provide pipeline to deliver the gas of Azerbaijan in Europe for the next 8 years.

Justification of the Real Option

So, how do we justify that this Real Option is feasible and that there is some possibility that it
can happen and it will be beneficial to BP. In the beginning of the case it is clearly mentioned
that British petroleum has been successful with their oil projects in Azerbaijan. In recent study, it
has been shown that, inflation is increasing in Azerbaijan continuously which will eventually cut
down oil prices. Researchers estimated the forecasted sales growth of 2.3% in from 2017 to 2022
which is very low compare to the last decade. Since almost 57.3% of Azerbaijans economy
contributed by energy sector, gas production could be a better option for British Petroleum in
terms of investment in Azerbaijan. There is a lack of financial & technological in Azerbaijan to
utilize their natural resources, it could be a good option for British Petroleum to for the Shah
Deinz 2 project along with Shallow water Absheron Peninsula PSA.

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Valuation of Real Option

Here is the financial perspective for this Real Option. British Petroleum will have to invest an
amount of $15 billion & rest of the investment by associated company in order to start this Joint
Venture. As a result of which they will be able to attain benefit for 8 years. Here is the
probability distribution of annual cash flow that they might receive.

Probability, Pi Cash flow, CF (Billions) Pi*CF


0.1 7.5 .75
0.20 9 1.8
0.35 6.5 2.275
0.25 10 2.5
0.1 13 1.3
Expected CF 8.625

For simplicity we have assumed a Discounting Rate of 10% and a Risk Free Rate of 5%. British
Petroleum will have 5 years before they can decide whether to exercise this option.
Based on this information we are going to do a valuation of this option using the Black-Scholes
Model. Here is the complete Valuation process.

Investment 1 2 3 4 5 6 7 8 PV Return,Ri Pi Ri*Pi (Ri-R)^2*Pi


15 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 $3.50 ($11.50) 0.1 -1.15012 0.22099883
15 9 9 9 9 9 9 9 9 $4.20 ($10.80) 0.2 -2.16029 0.12382403
15 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5 ($8.50) 0.35 -2.975 0.8028958
15 10 10 10 10 10 10 10 10 $4.67 ($10.33) 0.25 -2.58373 0.02565355
15 13 13 13 13 13 13 13 13 $6.06 ($8.94) 0.1 -0.89354 0.1164646

R= ($10.01) -9.76268
Std. Dev 0.31237031
Discounting rate 0.1 Variance 0.09757521
Year 8

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S $28.2408
X $15
Std. Dev. 0.31237
Variance 0.097575
R 5%
Time 5 yrs.
d1 0.699343
d2 0.000862
q 0

N(d1) 0.757831
N(d2) 0.000862

C $21.39169

Where, = (1) (2)


Thus, we can say that this Real Option can be considered by British Petroleum, as it has a value
of $21.391.
Analysis of the Case:

Well, the case begins with the introduction of Samira Bayramli who is in charge of making a
decision of what to do regarding the Absheron Project in Port Baku in Azerbaijaan. The $5178
million project is in the hands of British Petroleum, the question is whether she will be able to
come up with proper analysis of the situation or not.

As per the calculation presented in the case, Samira Byramli considered a project discount rate of
8% and arrived at a NPV of $729 Million and IRR of 11.5% on the whole project and 50% on
their proportionate ownership and a Cost of equity of 50%. On this basis only and given that no
other information is given us, the project can be accepted and on the basis of NPV and IRR.

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They have not made any calculation regarding MIRR. But the most important thing that we need
to consider is the Country Risk and Simulation Risk. If we consider a premium of 3% for
Country Risk and 2% Sensitivity Risk, we arrive at a project discounting rate of 13%.
If we discount the cash flow with this new Premium Adjusted discounting rate, the NPV
becomes negative with a value of $293 Million & IRR remain unchanged. So, now whether we
should accept or reject the project is the biggest question for the analysts. We will now look for
alternative course of action.

Alternative Courses of Action

The current plan of action for British petroleum is to go for a shared ownership with SOCAR.
with an ownership percentage 50% for with SOCAR, in which BP will provide approximately
50% of the total Equity and remainder by the SOCAR. It may seem less but the only alternative
that British Petroleum had to ignore a joint ventureand execute the entire project using their
funds or to back out from the project.

Analysis of the Courses of Actions

For this alternative, we are going consider that BP is going for the plan of getting a 100%
ownership of the project. This means a financing decision of $10,355 million. For simplicity we
are assuming that whole project will be financed is 100% equity. Alongside the $10,355 million
investment, we are going to add an additional $50 million as licensing fee to operate in
Azerbaijan, as this time there is no joint venture involved with any Azerbaijan company. The
following tables represent the figures we are going to use for arriving at the new NPV given that
the full ownership will now belong to BP.Cost of Equity has been calculated using the CAPM
approach. The equation is given below,

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= + ( )

Given that information was no properly provided in the case, we have assumed the Risk-Free
Rate, which is the rate of US T-Bond as 10% and the Market Return as 15% & beta is 0.5.
Cost of equity = 10% + (15%- 10%) * 0.5 = 12.5%
Since BPs investment will be solely by 100% equity, weighted average cost will be the cost of
equity.
Adjusted Cost of equity = Cost of equity + Country risk premium + Sensitivity risk premium
= (12.5% + 3% + 2%) = 17.5%

Considering the inflation of 5%,


Inflation adjusted cost of equity = (1+0.175/1-+.05) -1 = 11.90 %
Using this Final Cost of Capital Value and including the new initial investment, we have
recalculated our NPV, IRR and MIRR.

BP IRR 27.71%
BP NPV $7,301
BP PAYBACK 8.37 years
MIRR 16.54%

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For Cost of equity, we decided to take a uniform distribution with an initial value of 11.90 and
standard deviation of 1.19.

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So, on the basis of our calculation, we have found out the above value. The real question should
this be a viable alternative?

The project has a positive NPV which is a good indicator for accepting the project.
The projects IRR & MIRR, both are greater than the Inflation Adjusted Cost of Equity
we have calculated.
All three major capital budgeting techniques have given us good indication about the
alternative. So, based on this analysis BP can consider the alternative if they feel the
justification is satisfactory for accepting the project.

Total value of this project with


growth opportunity = $21.39 + $7,301= $7322.39 million

Recommendation

There is a significant difference in the NPV, IRR and MIRR values. The project with our new
proposal and calculation brings more promising figures which we believe the management would
like to consider as we have taken into consideration of the Country Risk and Sensitivity Risk.
Thus, BP should go the alternative that we have proposed rather than the one they have
originally arrived at.

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