Professional Documents
Culture Documents
Mai 2004
Investment decisions
Investment decisions are among the most important decisions that a company/government can take
capital intensive irreversible high risk/uncertainty
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DROP Develop
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.
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Investment analysis
..main economic terms
Investment analysis- main economic terms
Cash-flow
inflation time value of money uncertainty
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Analysis
Establish a cash-flow prognosis Nominal/real values Discount the cash flow Consider the uncertainties Net Present Value
Invest
Investment decision
Drop
Wait
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Cash-flow
..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)
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Cash-flow
Budgeting techniques are used to calculate the projects cash-flow for every year:
Year 1:
Cash-flow
over the life-time of the project
Year t
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Cash-flow
...an oil investment - 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
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Cash-flow
..comparing cash-flow elements over time
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Cash-flow
..inflation
As long as there is inflation, the consumers purchasing power (i.e. what you can buy) for 10$ will be reduced the later you receive the money. You could buy more for 10$ in 1960 than in 2004 - and probably more in 2004 than in 2010 We adjust for inflation by using real values instead of current values
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Cash-flow
..inflation - from current to real values (to deflate)
2005 212$
2006 449$
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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-flow
..Time value of Money
Even after you have adjusted for inflation, it is not correct to simply add up in-flow and out-flow of the project. Assume the bank offers an interest rate equal to 5 %.
2004 Example 1 Example 2
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2005 1$5cent 1$
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1$ 92,5cent
Cash-flow
..Time value of Money an example Bank deposit: Annual interest rate:
After 1 year: After 2 years: V1 V2
$ 100 10 %
= $100 * (1 + 0.10) = $110.0 = $110 * (1 + 0.10) = $100*(1 + 0.10)*(1 + 0.10) = $100 * (1 + 0.10)2 = $121.0 = $121*(1 + 0.10) = $100*(1 + 0.10)3 = $133.1
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After 3 years:
etc
V3
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Cash-flow
..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
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Cash-flow
..Time value of Money present value
Vn Vo = (1 + r)n
To calculate the present value is often called discounting
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Cash-flow
..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-flow
..discounting a cash-flow - Net Present value -an example
1 Calculate separately the present value of all the cashflow elements
Time Cash-flow Present value:
0 1 -100 80
2 70
-100 75 62
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80/(1.06) 70/(1.06)2
interest rate is 6%
Cash-flow
..a summary
Future in- and out-flow have to be discounted to be comparable. The present value of a project is the sum of discounted cash-flow elements. You have to use the rate of return of the best alternative use of money as the discount rate. Then the net present value means the increase in value by choosing this project instead of the best alternative.
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Cash-flow
..uncertainty
There is always some uncertainty in investment analysis. The future cash-flow can not be projected with certainty at the time of investment. As long as today is more certain than the future, there is a third reason to prefer money today instead of tomorrow - we are risk averse
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Cash-flow
..uncertainty - risk premium
Risk averse people will demand a compensation for taking risk - they want a risk-premium. You can express this by correcting the discount-rate
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Cash-flow
..uncertainty - risk premium
By investing in a diversified (varied) project portfolio, 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.
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Cash-flow
..uncertainty - risk premium an example
An oil company has estimated the following cash flow for an oil project: (-800, -900, 200, 130, 600 per year in 9 years, 400, 300, 50) Risk free discount rate is 7% but the company is very risk averse and want a risk premium of 10%. Calculate the NPV of the project.
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Cash-flow
..uncertainty - risk premium an example
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
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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
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NPV
2131
415
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0 1 -100 80
2 70
-100 75 62
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80/(1.06) 70/(1.06)2
interest rate is 6%
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Project A B C
The net present value concept: Accept project A Accept project B Drop project C
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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
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Discounted cash-flow
Present Value
60 41 25 10 0 -3 -14
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IRR
Discount rate
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Pay-back
The time required for an investment to generate sufficient cashflow to recover the initial capital investment
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Then NPV is the best suited decision criteria, and positive NPV means that the project is profitable.
Go ahead with the investment!
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