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Mai 2004

PPM 2nd Workshop of the China Case Study

1

Investment decisions

Investment decisions are among the most important decisions that a company/government can take

capital intensive irreversible high risk/uncertainty

Mai 2004

PPM 2nd Workshop of the China Case Study

2

DROP DROP 3D seismic Drill a wild-cat DROP Appraisal Investment analysis is used as a managerial tool to take such decisions Mai 2004 DROP Develop PPM 2nd Workshop of the China Case Study 3 Objectives Basic knowledge and techniques for performing investment analysis Use the tools and concepts on petroleum investment projects A field development project An exploration project Be able to understand the concepts used and do the economic calculations needed in the case study. Mai 2004 PPM 2nd Workshop of the China Case Study 4 . .Decisions through the life-cycle of a petroleum project DROP Apply/bid license Accept work progr In all these phases you have to take decisions.

Investment analysis .main economic terms Investment analysis.main economic terms Cash-flow inflation time value of money uncertainty Economic Decision Criteria net present value internal rate of return (IRR) payback & maximum exposure Mai 2004 PPM 2nd Workshop of the China Case Study 5 Main elements in economic investment analysis Idea Analysis Establish a cash-flow prognosis Nominal/real values Discount the cash flow Consider the uncertainties Net Present Value Invest Investment decision Drop Wait Mai 2004 PPM 2nd Workshop of the China Case Study 6 ..

costs = Net cash flow Mai 2004 PPM 2nd Workshop of the China Case Study 8 ..the starting point of an investment analysis What cash flow will be generated in & out? Why concerned about the cash flow? Investor invests $ today (out flow) hoping to harvest more $ in the future (inflow) Mai 2004 PPM 2nd Workshop of the China Case Study 7 Cash-flow Budgeting techniques are used to calculate the projects cash-flow for every year: Year 1: Income .Cash-flow .

costs = Net cash -flow Income .Cash-flow …over the life-time of the project Income .costs = Net cash -flow Year t Mai 2004 0 PPM 2nd Workshop of the China Case Study 1 2 9 Cash-flow ..an oil investment .costs = Net cash -flow Income .the investment projects cash-flow Cash in-flow (income) 1200 1000 800 600 400 200 0 -200 -400 -600 1 3 5 7 9 11 13 15 17 19 21 23 25 years 10 Cash out-flow (costs) Mai 2004 PPM 2nd Workshop of the China Case Study ..

e. the consumers purchasing power (i.Cash-flow .and probably more in 2004 than in 2010 We adjust for inflation by using real values instead of current values Mai 2004 PPM 2nd Workshop of the China Case Study 12 .inflation As long as there is inflation.comparing cash-flow elements over time We can’t simply add up inflow and outflow. due to Inflation Time Value of Money Uncertainty Mai 2004 PPM 2nd Workshop of the China Case Study 11 Cash-flow . You could buy more for 10$ in 1960 than in 2004 .. what you can buy) for 10$ will be reduced the later you receive the money..

.06)2 = 400$ = 200$ Mai 2004 PPM 2nd Workshop of the China Case Study 13 Cash-flow Cash in-flow (income) 1200 1000 800 600 400 200 0 -200 -400 -600 1 3 5 7 9 11 13 15 17 19 21 23 25 years .inflation Cash out-flow (costs) Mai 2004 PPM 2nd Workshop of the China Case Study 14 .Cash-flow .06)$ 449/(1+0.from current to real values (to deflate) 2004 Current value Real 2004 value -1000$ 2005 212$ 2006 449$ -1000$ 212/(1+0..inflation .

10) = $100*(1 + 0.10) = $110. 2004 Example 1 Example 2 Mai 2004 2005 1$5cent 1$ 15 1$ 92.1 16 After 3 years: etc V3 Mai 2004 PPM 2nd Workshop of the China Case Study .0 = $121*(1 + 0.10) = $100 * (1 + 0.10) = $100*(1 + 0.5cent PPM 2nd Workshop of the China Case Study Cash-flow .10)*(1 + 0.Time value of Money – an example Bank deposit: Annual interest rate: After 1 year: After 2 years: V1 V2 $ 100 10 % = $100 * (1 + 0.Cash-flow . it is not correct to simply add up in-flow and out-flow of the project.10)2 = $121.. Assume the bank offers an interest rate equal to 5 %.0 = $110 * (1 + 0..10)3 = $133.Time value of Money Even after you have adjusted for inflation.

Time value of Money – present value Vn Vo = (1 + r)n To calculate the present value is often called discounting Mai 2004 PPM 2nd Workshop of the China Case Study 18 .Time value of Money – end value Vn Vo r = the amount of money we can take out of the bank after n years = the amount of money we put in the bank today = a fixed interest rate in % per year Vn = Vo (1 + r)n Mai 2004 PPM 2nd Workshop of the China Case Study 17 Cash-flow ..Cash-flow ..

Net Present value -an example 1 Calculate separately the present value of all the cashflow elements Time Cash-flow Present value: 2 Add together the discounted cash-flow elements 0 1 -100 80 2 70 -100 + 75 + 62 = 37 The net present value of the cashflow of the project is 37 20 -100 75 62 Mai 2004 80/(1..Time value of Money Cash in-flow (income) 1200 1000 800 600 400 200 0 -200 -400 -600 1 3 5 7 9 11 13 15 17 19 21 23 25 years Cash out-flow (costs) Mai 2004 PPM 2nd Workshop of the China Case Study 19 Cash-flow .discounting a cash-flow ..Cash-flow .06) 70/(1.06)2 interest rate is 6% PPM 2nd Workshop of the China Case Study .

and out-flow have to be discounted to be comparable.a summary Future in. As long as today is more certain than the future. The future cash-flow can not be projected with certainty at the time of investment. Mai 2004 PPM 2nd Workshop of the China Case Study 21 Cash-flow .uncertainty There is always some uncertainty in investment analysis.. there is a third reason to prefer money today instead of tomorrow .. Then the net present value means the increase in value by choosing this project instead of the best alternative.we are risk averse Mai 2004 PPM 2nd Workshop of the China Case Study 22 . You have to use the rate of return of the best alternative use of money as the discount rate. The present value of a project is the sum of discounted cash-flow elements.Cash-flow .

Cash-flow .uncertainty ..uncertainty .they want a risk-premium. You can express this by correcting the discount-rate Mai 2004 PPM 2nd Workshop of the China Case Study 23 Cash-flow . Mai 2004 PPM 2nd Workshop of the China Case Study 24 .risk premium By investing in a diversified (varied) project portfolio..risk premium Risk averse people will demand a compensation for taking risk . you can lower your total risk exposure Only the the change of risk an individual project contribute to an investment portfolio is relevant for compensation.

. 50) Risk free discount rate is 7% but the company is very risk averse and want a risk premium of 10%. 600 per year in 9 years.. Mai 2004 PPM 2nd Workshop of the China Case Study 25 Cash-flow . 130.uncertainty .risk premium – an example Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Mai 2004 Real Discounted Discounted cash flow 7 % 17 % -800 -800 -800 -900 -841 -769 200 175 146 130 106 81 600 458 320 600 428 274 600 400 234 600 374 200 600 349 171 600 326 146 600 305 125 600 285 107 600 266 91 400 166 52 300 116 33 50 18 5 4780 PPM 2nd Workshop of the China Case Study NPV 2131 415 26 . 200. Calculate the NPV of the project. 400. -900.Cash-flow .uncertainty . 300.risk premium – an example An oil company has estimated the following cash flow for an oil project: (-800.

discounting a cash-flow . Mai 2004 PPM 2nd Workshop of the China Case Study 27 Economic Decision Criteria .06)2 interest rate is 6% PPM 2nd Workshop of the China Case Study .06) 70/(1.Net Present Value -an example 1 Calculate separately the present value of all the cashflow elements Time Cash-flow Present value: 2 Add together the discounted cash-flow elements 0 1 -100 80 2 70 -100 + 75 + 62 = 37 The net present value of the cashflow of the project is 37 28 -100 75 62 Mai 2004 80/(1.Economic Decision Criteria In this part we will see how how to use cash-flow and discounting to decide whether a project is economic or not..

.140) (-390. 220) (-600.Net Present Value The Net present value (NPV) concept says: Accept all projects with NPV > 0 Drop all projects with NPV < 0 If NPV = 0. 350) Present Value 25 37 -38 The net present value concept: Accept project A Accept project B Drop project C Mai 2004 PPM 2nd Workshop of the China Case Study 30 . 120.Economic Decision Criteria .. we are indifferent between accepting or dropping the project Mai 2004 PPM 2nd Workshop of the China Case Study 29 Economic Decision Criteria . . .Net Present Value – an example Discount rate: 10% Project A B C Cash-flow (-200. 300. 270.

20)2 -200+120/(1. – Internal Rate of Return The discount rate that yields NPV=0 defines the Internal Rate of Return (IRR) Accept all project with IRR > discount factor Drop all project with IRR < discount factor If IRR = discount factor we are indifferent Mai 2004 PPM 2nd Workshop of the China Case Study 31 Economic Decision Criteria .20)+140/(1.25)+140/(1.15)2 -200+120/(1. – Present Value Profile – an example Discount rate (%) 0 5 10 15 18.9 20 25 Mai 2004 Discounted cash-flow Present Value -200+120/(1.15)+140/(1.00)2 -200+120/(1.Economic Decision Criteria ..10)2 -200+120/(1.05)+140/(1.05)2 -200+120/(1.25)2 PPM 2nd Workshop of the China Case Study 60 41 25 10 0 -3 -14 32 .10)+140/(1..189)+140/(1.189)2 -200+120/(1.00)+140/(1.

9 2 0 2 5 .Economic Decision Criteria NPV 7 0 6 0 5 0 4 0 3 0 2 0 1 0 0 0 -1 0 -2 0 5 1 0 1 5 1 8 . Pay-back The time required for an investment to generate sufficient cashflow to recover the initial capital investment Mai 2004 PPM 2nd Workshop of the China Case Study 34 . – present value profile – an example IRR Discount rate Mai 2004 PPM 2nd Workshop of the China Case Study 33 Economic Decision Criteria Maximum Exposure The maximum negative cash-flow on a project..

and positive NPV means that the project is profitable. Go ahead with the investment! Mai 2004 PPM 2nd Workshop of the China Case Study 35 .Economic Decision Analysis The results and the quality of the economic analysis depends on The quality of the cash-flow elements If the discount rate reflects the best alternative value of the money Then NPV is the best suited decision criteria.

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