# 6 c b d a npv npv base case ratio of varied parameter

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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 A NPV 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 upstream. 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 conditional probabilities.” 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.

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