It also means that it is critical that discounted

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Unformatted text preview: process map in figure 5.1, estimates must be generated of the values in a decade’s time of variables, some of which are notoriously volatile, such as, oil price and inflation. It also means that it is critical that discounted cash flow (DCF) techniques are adopted in investment appraisal (Simpson et al., 1999). The most well known DCF tool is the net present value (NPV) method and it will be reviewed here. The intention is to give only a brief overview of NPV. More detailed explanations can be found in finance and economics texts (for example, Atrill, 2000; Brealey and Myers, 1996; Drury, 1985; Weston and Brighman, 1978). Total net profit from investment Cumulative net cash positions 0 Payback period Time Initial investment Figure 5.2: Cumulative cash position curve (source: adapted from Newendorp, 1996 p14) As indicated above, when money is invested in a project a commitment of funds is generally required immediately. However, the flow of funds earned by the investment will occur at various points of time in the future. Clearly, receiving £1000 in, for example, a year’s time is less attractive than receiving £1000 now. The £1000 now could be invested so that in a year’s time it will have earned interest. This implies that money that will be earned in the future should be discounted so that its value can be compared with sums of money being held now. This process is referred to as discounting to present value (Goodwin and Wright, 1991 p147). 76 The severity with which future sums of money are discounted to their present value is a function of the discount rate applied. Determining the appropriate discount rate for a company’s potential investment project is, ultimately, a matter of judgement and preference. However, many attempts have been made to make the choice of a discount rate as “objective” as possible, making this a complex area which is beyond the scope of this thesis. Edinburgh based oil industry analysts Wood Mackenzie’s base case nominal discount rate is made up of four different elements: • The risk-free real rate of return available through an index-linked, long-term gilt yield. This comprises the real rate of interest known at the time of purchase and whatever inflation rate occurs over the period of redemption. • An assumption of the long-term inflation rate. • The equity risk premium. This is the return expected by equity investors over and above the return on risk free assets. A premium is required because equity returns – like upstream investments – can only be estimated and are not guaranteed. • The exploration risk premium. Oil companies are generally perceived as being “riskier” than the equity market (Wood Mackenzie, 1998). For many situations it is convenient to let the discount rate reflect the opportunity cost of the capital which is being invested. Most firms now using the NPV measure of profitability appear to be using discount rates in the range of 9% to 15% for petroleum exploration investments. Some companies adopt a higher discount rate as a crude mechanism for quantifying risk and uncertainty (Newendorp, 1996 pp35-36). This is...
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This document was uploaded on 03/30/2014.

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