1.6 Measures of Value 2014 (14)

8/10/2019 1.6 Measures of Value 2014 (14)

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Measures of Value

A monetary amount received today is more valuable thanthe same monetary amount received at some time in thefuture.

October 2014


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Time Value of Money

Most people would prefer to receive a given amount ofmoney today rather than at some time in the future.

Why? Money received today can be invested, spent or put under the

bed! Money due for receipt in future is at risk; dividends may not be

paid, inflation may erode purchasing power or the entity owingyou the money might go broke.

For these reasons, it is important to take the time value

of money into account, especially for investments of along term nature such as oilfield development projects.


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The Concept of Interest

Compound Interest

Vt = V0 (1 + r ) t

Where:

Vt = value after t years V0 = amount investedr = annual rate of interest

This assumes the interest paidis reinvested at the samerate of interest.

Simple Interest

Vt = V0+V0r t

Where:

Vt = value after t years V0 = amount investedr = annual rate of interest

This assumes the interest paid isNOT reinvested .

Now

$100 invested at 8% interest

1 Year Later

Bank pays out $108


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Discounting Example

A business receives the following cash amounts during a five yearperiod. What is the present value (PV) of these amounts at a discountrate (r) of 12%?

1 Discount factor for year 1 = = 0.8929

(1 + 0.12) 1

Thus discounting can be thought of as compound interest in reverse!

Year Amount DiscountFactor

PV

1 3000.00 0.8929 2678.57

2 3200.00 0.7972 2551.02

3 2300.00 0.7118 1671.104 4700.00 0.6355 2986.94

5 3875.00 0.5674 2198.78

Total 17075.00 12086.40


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Project Cash Flow Oil companies must generate enough revenue from investments

(projects) to cover the cost of capital and of operating thebusiness. In the example below, the company breaks even.

ShareholdersBanks

Investment Houses

Oil Company

ProjectCAPEX/OPEX

$100 $90

$108 $108

General Overheadsand Expenses

$10

InvestmentOne - Year Life Cycle

RequiredROR fromProject

= 20%


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Choosing the Discount Rate Discount rates may be chosen with reference to a companys cost of

capital: Weighted average cost of capital (WACC) or the capital asset pricingmodel (CAPM)

Opportunity cost of capital. The oppo r tun i ty cos t o f cap i tal can be thought of as the difference

in return expected from a chosen project and an investment of similarrisk that is necessarily forgone.

Very often the opportunity cost of capital is defined in terms of theoverall rate of return of the business.

This definition, though not rigorous, does define the minimum returnstandard acceptable to the company with the proviso that thebusiness is performing well in comparison to its peers.

Most companies that fund projects from retained profits use theopportunity cost of capital as their discount rate. If a project does not equal or exceed the opportunity cost of capital, it

is usually rejected. Strategic and/or political reasons may result in some projects being

accepted in spite of failing to meet the economic criteria.


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MOD and RCF for the RGC Field

This cash flow table was shown in the topic on cash flows. RCF = 93.8 million. What is the net present value NPV of the real cash flows over the

field life cycle if a discount rate of 10% is chosen?

Cash Flow Projection - 4.00% InflationOil Price ($/bbl) 40 Inflation 4.0% Effective tax rate 60.0%

Year Prod Infl Revenue CAPEX Cap OPEX Taxable Tax C/F C/FFactor BYR MOD BYC MOD Allow BYC MOD Income MOD Real

MMBbl $m $m $m $m $m $m $m $m $m $m1 0.0 1.040 0.0 0.0 140.0 145.6 0.0 0.0 0.0 0.0 -145.6 -140.02 0.0 1.082 0.0 0.0 95.0 102.8 5.0 5.4 0.0 0.0 -108.2 -100.03 4.0 1.125 160.0 180.0 62.1 21.0 23.6 94.3 56.6 99.8 88.74 3.5 1.170 140.0 163.8 62.1 16.0 18.7 83.0 49.8 95.3 81.4

5 3.0 1.217 120.0 146.0 62.1 16.0 19.5 64.4 38.7 87.9 72.26 2.8 1.265 112.0 141.7 62.1 15.0 19.0 60.6 36.4 86.3 68.27 1.6 1.316 64.0 84.2 14.0 18.4 65.8 39.5 26.3 20.08 0.5 1.369 20.0 27.4 12.0 16.4 10.9 6.6 4.4 3.2

146.2 93.8Capital allowance = 25% per year after first oil Oil price remains flat in real terms.


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Net Present Value (NPV)

To obtain the present value of a series of cashflows each years real net cash flow is discounted back to

present day values at the corporate discount rate. the sum of all the discounted cash flows is the NPV of

the investment or project. For the RGC Field example, the project NPV

= (PV) = $7.5 million. Compare this to the sum of real net cash flows =

$93.8 million.
http://localhost/var/www/apps/conversion/tmp/scratch_6/RGC%20Cash%20Flow%20Spreadsheets.xls


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Observations on NPV

NPV provides a common measure of value for projectshaving different life cycles and cash flow patterns. Provided the discount factor meets the companys

minimum return standard, an NPV of zero implies that

the project or investment is economically viable. Factors that influence whether a project is given the goahead include availability of funds, how the project fitsin with corporate objectives and an assessment of thetechnical, financial and political risks.

Sensitivity analyses are performed to test the impact ofsome of these risks.
http://localhost/var/www/apps/conversion/tmp/scratch_6/RGC%20Cash%20Flow%20Spreadsheets.xls


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Measure of Profitability

Prof i tabi l i ty Ind ex (Pi) is the ratio of the discounted cashflow plus the discounted investment value to thediscounted investment value.

Pi = [ (RCF t DF t) + (CI t DF t)]/ (CIt x DF t)For RGC field, Pi = (7.5 + 127.3 + 82.6)/(127.3 + 82.6)

Pi = 1.036

A Pi > 1.0 will always result if the NPV > 0

Due to differences in cash flow timing, project rankings canchange if the discount rate is changed.


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Effect of Changing Discount Rate

Project C is ranked top for RCF (Discount rate = 0%)

Project C is also top at a discount rate of 10%. At 15% Project B is ranked marginally above C Above 15%, Project A looks best. Since smaller companies tend to have higher costs of

capital than the majors, what does this imply?

Discount NPV ($ x 1000) ProjectRate A B C Ranking

0% 10000 12000 13000 C5% 7565 8733 9296 C

10% 5574 6105 6336 C15% 3927 3967 3945 B20% 2548 2208 1992 A25% 1382 748 383 A


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Internal Rate of Return (IRR)

IRR is defined as the rate of return resulting in an NPV of zero. If a project has an NPV = 0, the IRR is the same as the discount rate

used in the evaluation. 0 = RCF t / (1 + r*) t where r* is the IRR. IRR is found by trial and error and is quite easy to obtain if a spreadsheet

approach is employed. For the RGC field IRR is 11.28%.

RGC Field PV Profile

-60

-40-20

0

20

40

60

80

100120

0 5 10 15 20 25

Discount Rate %

N P V $ M i l l i o n


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Potential Problems with IRR

IRR implicitly assumes that funds generated in a project can be

reinvested at a rate equal to the IRR. This is not always feasible. The NPV method assumes that funds are reinvested at the

corporate minimum rate of return, which by definition is achievable. Note that the IRR formula is a n th degree polynomial with n roots. Normally only one solution is real, but with cash flow reversals, e.g.

acceleration projects, multiple roots can occur.

RGC Field PV Profile

-60

-40

-20

0

20

40

60

80

100

120

0 5 10 15 20 25

Discount Rate %

N P V $ M i l l i o n IRR = 11.28%

Documents

1.6 Measures of Value 2014 (14)