Measures of Value

A monetary amount received today is more valuable than

the same monetary amount received at some time in the
future.

October 2014

Time Value of Money

Most people would prefer to receive a given amount of
money 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 owing
you the money might go broke.

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

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

The Concept of Interest

Now
$100 invested at 8% interest

Simple Interest

Vt = V0+V0r t

1 Year Later
Bank pays out $108

Compound Interest

Vt = V0 (1 + r )t

Where:
Vt = value after t years
V0 = amount invested
r = annual rate of interest

Where:
Vt = value after t years
V0 = amount invested
r = annual rate of interest

This assumes the interest paid is

NOT reinvested.

This assumes the interest paid

is reinvested at the same
rate of interest.

Discounting
Lets turn the interest concept around!

Now
$92.5926 invested at 8%

1 Year Later
Bank pays out $100

$100 received after one year has a present value (PV) of $92.5926 at
a discount rate of 8%.
To obtain the PV of expected cash flows from a project, we have to
discount the cash received each year back to the present at a
discount rate (r) related to the corporate cost of capital.
1
Discount factor =
where n is the year in question.
(1 + r)n
Thus discounting can be thought of as compound interest in reverse!

Discounting Example
A business receives the following cash amounts during a five year
period. What is the present value (PV) of these amounts at a discount
rate (r) of 12%?
1
Discount factor for year 1 =
= 0.8929
(1 + 0.12)1
Year

Amount

Discount
Factor

PV

3000.00

0.8929

2678.57

3200.00

0.7972

2551.02

2300.00

0.7118

1671.10

4700.00

0.6355

2986.94

3875.00

0.5674

2198.78

Total

17075.00

12086.40

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

Project Cash Flow

Oil companies must generate enough revenue from investments
(projects) to cover the cost of capital and of operating the
business. In the example below, the company breaks even.
Investment
One - Year Life Cycle
Shareholders
Banks
Investment Houses

$108

Project
CAPEX/OPEX

$108

$100

$90

Oil Company

Required
ROR from
Project
$10
General Overheads
and Expenses

= 20%

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 pricing
model (CAPM)
Opportunity cost of capital.

The opportunity cost of capital can be thought of as the difference

in return expected from a chosen project and an investment of similar
risk that is necessarily forgone.
Very often the opportunity cost of capital is defined in terms of the
overall rate of return of the business.
This definition, though not rigorous, does define the minimum return
standard acceptable to the company with the proviso that the
business is performing well in comparison to its peers.
Most companies that fund projects from retained profits use the
opportunity 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.

MOD and RCF for the RGC Field

Cash Flow Projection
Oil Price ($/bbl)
Year

Prod
1
2
3
4
5
6
7
8

MMBbl
0.0
0.0
4.0
3.5
3.0
2.8
1.6
0.5

40
Infl
Factor
1.040
1.082
1.125
1.170
1.217
1.265
1.316
1.369

4.00% Inflation
Inflation

4.0%

Effective tax rate 60.0%

Revenue
CAPEX
Cap
OPEX
Taxable
BYR MOD BYC MOD Allow BYC MOD Income
$m
$m
$m
$m
$m
$m
$m
0.0
0.0 140.0 145.6
0.0
0.0
0.0
0.0
0.0
95.0 102.8
5.0
5.4
0.0
160.0 180.0
62.1
21.0
23.6
94.3
140.0 163.8
62.1
16.0
18.7
83.0
120.0 146.0
62.1
16.0
19.5
64.4
112.0 141.7
62.1
15.0
19.0
60.6
64.0
84.2
14.0
18.4
65.8
20.0
27.4
12.0
16.4
10.9

Capital allowance = 25% per year after first oil

Tax
$m
0.0
0.0
56.6
49.8
38.7
36.4
39.5
6.6

C/F
MOD
$m
-145.6
-108.2
99.8
95.3
87.9
86.3
26.3
4.4
146.2

C/F
Real
$m
-140.0
-100.0
88.7
81.4
72.2
68.2
20.0
3.2
93.8

Oil price remains flat in real terms.

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?

Net Present Value (NPV)

To obtain the present value of a series of cash
flows
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.

Observations on NPV

NPV provides a common measure of value for projects

having 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 go
ahead include availability of funds, how the project fits
in with corporate objectives and an assessment of the
technical, financial and political risks.
Sensitivity analyses are performed to test the impact of
some of these risks.

Measure of Profitability
Profitability Index (Pi) is the ratio of the discounted cash
flow plus the discounted investment value to the
discounted investment value.
Pi = [ (RCFt DFt) + (CIt DFt)]/ (CIt x DFt)
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 can
change if the discount rate is changed.

Effect of Changing Discount Rate

Discount
Rate
0%
5%
10%
15%
20%
25%

NPV ($ x 1000)
Project
A
B
C
Ranking
10000
12000
13000
C
7565
8733
9296
C
5574
6105
6336
C
3927
3967
3945
B
2548
2208
1992
A
1382
748
383
A

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?

Internal Rate of Return (IRR)

RGC Field PV Profile
120
100
NPV $ Million

80
60
40
20
0
-20 0

10

15

20

25

-40
-60
Discount Rate %

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 = RCFt / (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%.

Potential Problems with IRR

RGC Field PV Profile
120
100
NPV $ Million

80

IRR = 11.28%

60
40
20
0
-20 0

10

15

20

25

-40
-60
Discount Rate %

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 nth degree polynomial with n roots.
Normally only one solution is real, but with cash flow reversals, e.g.
acceleration projects, multiple roots can occur.