Unformatted text preview: eral disadvantages. One such disadvantage is
highlighted here. The others are discussed in the section of this chapter that is
concerned with option theory (section 5.6). C B D
NPV base case
Ratio of varied parameter to base case Figure 5.3: Typical spider diagram (where NPV is the dependent variable and A, B, C and D are
factors in the economic analysis) The NPV approach assumes the values of the input parameters are known. For
example, in the case of the petroleum industry, its use presumes the analyst knows the
original oil-in-place, decline rate, the oil price for each year of production, costs for
each year, discount rate and tax structure, amongst others (Galli et al., 1999).
However, in almost all cases, there is uncertainty surrounding the input variables.
Expressing such parameters as single figures creates an illusion of accuracy. It also
means that the decision-maker has no indication as to how reliable the resulting
decision-making criterion is. Clearly, it would be much more realistic if there was a
mechanism for incorporating the uncertainty surrounding the cash flows into the 79 analysis. As indicated in Chapter 2, decision analysis techniques now exist and these
allow the dimensions of risk and uncertainty to be incorporated into investment
decision-making (Newendorp, 1996 p58).
Fundamental to decision analysis are the concepts of EMV and decision tree analysis.
Both these tools have received much attention in the decision analysis literature and
have been applied to numerous real and hypothetical examples in the industry
literature. In this section, the two concepts will be briefly outlined. Particular attention will be focussed on their impact on investment decision-making in the
The EMV concept is a method for combining profitability estimates of risk and
uncertainty to yield a risk-adjusted decision criterion. The expected value decision
rule holds that when choosing among several mutually exclusive decision alternatives,
all other factors being equal, the decision-maker should accept the decision alternative
which maximises the EMV. The EMV of a decision alternative is interpreted to be
the average monetary value per decision that would be realised if the decision-maker
accepted the decision alternative over a series of repeated trials. The key words in
this interpretation, particularly for exploration decisions, are “per decision” and
“repeated trials” as Newendorp (1996 p67) emphasises in the following excerpt:
“If the decision-maker consistently selects the alternative having the highest
positive expected monetary value his total net gain from all decisions will be
higher than his gain realised from any alternative strategy for selecting
decisions under uncertainty. This statement is true even though each specific
decision is a different drilling prospect with different probabilities and
This statement, he argues, is the essential element for any rational justification of the
use of expected value in business decisions. The remark suggests that, as long as
whenever the decision-maker makes an investment, he or she adopts the strategy of
maximising expected value, then he or sh...
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This document was uploaded on 03/30/2014.
- Summer '14
- The Land