Project Economics & Decision Making Training Course Manual Issued To: MDT International 45 Albert Street Aberdeen AB25 1XT United Kingdom Tel +44 1224 561521 Fax +44 1224 561530 Email info@mdtinternational.com http:/Avwww.mdtinternational.com Copytight © MDT Intemational 2004, Al rights reserved. No att ofthis publication covered by copyright may be reproduced, ord in rexieval sytem or transmitted in any form or by any meas, clesronic, mechanical, photocopying. recording or otherwise, without the prior ‘wrtan conan ofthe autho, ‘apes fr los oxasond to any pao ning o fining om an a rk fay karl inthis pblction can be sexpa thor,Project Economics & Decision Making Contents Introduction Sra u Course Objectives cece Si nae eo aire near Suggested Attendees... : 1 Criterion for Decision Making 2 The Project Life Cycle..... 7 eee, 3 Decision Analysis 4 Accountants’ vs Economists’ View of Financial Decisions ...... if Accountant’s Rate of Return ..... 8 Definition... 8 Criteria for Decision Making 8 o EXAMPLE - ACCOUNTANTS RATE OF RETURN 9 Critique of ARR Method escoessveseneeenueesinenueeenneetin 7 SOME esti UAW coTMaRIDR ee eee cece caca eens eee ees sees 10 Payback Period Method. 13 Investment Decision Criteria. 2 13 a EXAMPLE - PAYBACK PERIOD... - a 13 Critique of Payback Period Method 14 Present Value Concept - the Time Value of Money mae 15 a EXAMPLE - DISCOUNT FACTORS TABLE. ................sssssssesssssssesssssssssssse 16 a EXAMPLE - PRESENT VALUES. 17 The Cost of Capital... The Cost of Equity The P/E Growth Model. The Capital Asset Pricing (CAPM) Model.. ‘Net Present Value Method. eae 22 Investment Decision Criteria. 22 EXAMPLE - NET PRESENT VALUE... . aan Critique of NPV Method 23 Discounted Payback Period Method .... 224 EXAMPLE - DISCOUNTED PAYBACK PERIOD. 24 Project Economics & Decision Making 7 ©MDT Imernational 2004 C:MDT Training Public Zconomies REVISIONS 2004MfanualECONOMIC.DOC Ver 06Project Economics & Decision Making Critique of Discounted Payback Method......... Internal Rate of Return Method ... Definition. ( EXAMPLE- INTERNAL RATE OF RETURN. IRR Criteria for Decision Making... Critique of IRR Method (EXAMPLE - IRR Cash Flow “Change of Signs”. Profitability Index Method... Definition : Criteria for Decision Making (EXAMPLE - PROFITABILITY INDEX Critique of PI Method eee fesse NPV/Max Exposure Qo EXAMPLE - ‘NPV/MAX EXPOSURE.. Critique of NPV/MaxExp Method Methods Compared... (EXAMPLE - COMPARISON OF APPRAISAL METHODS....... Decision Making Under Capital Rationing (1 EXAMPLE - DECISIONS UNDER CAPITAL RATIONING. —_ EXAMPLE - COMPARISON OF NPVs The Impact of Rising Prices and Inflation. 1 EXAMPLE - RISING COSTS....... (EXAMPLE - INFLATION ADJUSTED DCF ‘The Impact of Exchange Rates... Oo EXAMPLE —- EXCHANGE RATES. The Impact of Taxation Introduction 0 UK Corporation Tax... Writing Down Allowances... im EXAMPLE - WRITING DOWN ‘ALLOWANCE Impact of Tax on the Cost of Capital. eaten fees EXAMPLE - IMPACT OF TAX ON COST OF: CAPITAL OG EXAMPLE - IMPACT OF TAX ON DISCOUNTED CASH FLOW Incremental Development Investment Criteria for Decision Making .... 46 Project Economics & Decision Making ©MDI International 2004 (C/MDI Training Public Economics REVISIONS 2004\Mfanual ECONOMIC.DOC Ver 06Project Economics & Decision Making Other Indicators .......... 49 (1 EXAMPLE - RELATIONSHIP OF ECONOMIC INDICATORS TO ACCOUNTING INDICATORS. Dealing With Uncertainty and Risk .......0 Payback Period : Maximum Exposure (EXAMPLE - MAXIMUM EXPOSURE Sensitivity Analysis. oe Spider/Star Diagrams .......c0ecnennncmnenensennnee Tornado Diagram... Probability Theory......-0-0- ease a 56 Decision Trees and Expected Monetary Value os 37 (EXAMPLE - DECISION TREE......... 58 Packaging the Proposal........ i a 59 Fundamental Management Questions. ee 59 Structuring Your Proposal 59 Project Objectives. 60 Project Scope.... 61 Project Schedule 61 Project Organisation eee 61 Project Economics i el Project Risk Assessment 61 Post Project Appraisal... eee ee 62 Project Economics & Decision Making iti ©MDT International 2004 ‘C:MDI Training Pubic Economies REVISIONS 2004\Manual\ECONOMIC DOC Ver 06OOO NTERNATIONAL Project Economics & Decision Making Introduction Course Objectives Do you need to: * prepare or review project expenditure proposals for management approval? * calculate the economic and financial benefits of a project proposal? * control project schedules and expenditure? This course aims to develop your skills in these areas and help you become more effective in your job. Particular emphasis will be placed on exploration, development, ‘maintenance and operations projects in the oil and gas industry. At the end of this course, participants will have gained skills to enable them to apply a structured approach to project justification and control. The course will enable delegates to: ‘* understand the use of economic evaluation techniques in project proposals ‘* calculate the economic and financial viability of expenditure proposals ‘* assess the ranking of alternative projects ‘* quantify the impact of risk and uncertainty when preparing project proposals * prepare project expenditure proposals in a way that will win management approval Suggested Attendees This course is aimed at personnel at all levels and all disciplines who have responsibility for project proposals and the management of projects. The course has been designed for the needs of the oil and gas E&P and service industries. Suggested attendees include: . project managers and engineers . maintenance managers, co-ordinators and specialists . facilities managers * information systems managers and project leaders . management accountants, finance and contracts specialists Project Economics & Decision Making 7 ©MDT International 2004 (CAMB Training Public Economies REVISIONS 2004 Mandi ECONOMIC.DOC Ver 06Project Economics & Decision Making Criterion for Decision Making ‘The underlying premise of this course is that decisions should be made in the best interests of the owners of a business. People, organisations and/or governments choose to own a business in order to become or remain wealthy. Wealth may be measured by the worth of the business or the income enjoyed from the proceeds of the business. Some owners” objective is to maximise business worth by achieving capital gains whilst other owners’ objective might be to maximise the income stream from their ownership. Ownership of a business requires some form of investment in the business. Owners face a choice of investing in their own business or investing elsewhere. Their choice to invest in their own business will be influenced by their assessment of the returns their investment will yield versus investment alternatives available and their own investment objectives The techniques described in this training course are aimed at improving and/or maintaining the wealth of the owners of or investors in a business. The techniques establish objective and empirical criteria for making decisions about investment and expenditure opportunities. CRITERION FOR DECISIONS Make the owners of the business wealthy Earn better return on investment than elsewhere Project Economics & Decision Making 2 ©MDT International 2004 C:MDT Training Puble\Economies REVISIONS 2004ManualECONOMIC.DOC Ver 06O0O (Pe neroe Project Economics & Decision Making The Project Life Cycle ‘A typical project can be thought of as having a beginning, its “Creation”, a middle, its “Implementation” and “Operation”, and an end, its “Termination”. This training course is particularly concerned with two of the early phases of a project - the Justification and Implementation. We will also consider the Termination phase, in particular the technique of Post Project Appraisal PROJECT LIFE CYCLE [>—> Identify objectives Identify solutions Evaluate alternatives Seek approval Control Create [Operation } Learning outcomes applied to next project Evaluate outcome Learn from outcomes Remember, your project is normally competing for funds within your organisation! This training course aims to improve your chances of obtaining those funds by providing tools and techniques for ensuring that you propose projects that fulfil ‘minimum commercial criteria Project Economics & Decision Making 3 ©MDI International 2004 (C:MADT Training Pubit\ Economies REVISIONS 2004\ManuaBCONOMIC DOC Ver 05iM] D]T) ie cheers Project Economics & Decision Making Decision Analysis ‘Accurate commercial decision making in the upstream petroleum business is particularly important due to: = the scale and size of investments and expenditures . the magnitude of rewards that are possible . the time periods over which these investments are made + the sizeable commercial risks involved . the number of variables involved ‘The technique of economic appraisal or analysis can play a vital role in petroleum industry commercial decisions: = ranking of which exploration prospects to drill + which prospects stand the best opportunities for commercial gain? + should they be drilled consecutively or concurrently? . whether to develop a petroleum reserve + willit earn money? + will it make sufficient money? + ranking which fields to develop where alternatives exist/constraints apply + which fields are most attractive financially + what priority might be attached to the development of the fields? + how to develop a petroleum reserve + fixed installation? — steel jacket? — concrete base? — manned or unmanned satellite? + floating production facility? + sub-sea completion and tie-in? + life of field Capex/Opex per BOE? + operating and manning philosophy? + howto transport or offtake petroleum from a field + tanker? + pipeline? + howto finance field development + issue more shares? Project Economies & Decision Making 7 ©MDT International 2004 CCAMDT Training\Pub ic Bconomics REVISIONS 2004\Mamual BCONOMIC.DOC Ver 06im] DIT) Pugs pace Project Economics & Decision Making . borrow? + farm-in/farm-out? . whether additional development wells should be drilled . what additional revenue must be earned from the wells, and how quickly, to make the investment of additional wells worthwhile? = whether to invest in enhanced recovery facilities during the life of the field + what additional revenue must be earned from the investment, and over ‘what period, to make the investment worthwhile? + when to cease production from an existing field + at what point in the production life cycle of a field does it become uneconomic to continue production? . whether to sell equity in existing licence blocks + are better returns on investment available to the company elsewhere? + is the cash today worth more than cash tomorrow or required for other purposes? + whether to purchase equity in other licence blocks + are better opportunities for return on investment available to the company elsewhere? + whether to "sole risk" a particular operation + are the inherent risks involved in sole risk activities worth the potential returns from the activity? + sit better to explore for new/additional/replacement reserves? + isit more cost effective to buy existing acreage? Whilst the ultimate end result from investment appraisal techniques are answers expressed as "arithmetic" answers, these should not be seen as the only factors which influence investment decisions. Other factors which will come into play in the upstream petroleum industry are: + the priorities of other joint venture companies and their availability of funds + operator vs non-operator + differences which may arise within a joint venture due to different companies taking a different view of the investment prospect and adopting different planning assumptions + non-operator’s dependence on the operator for information + the persuasiveness of the operator Project Economics & Decision Making 5 ©MDT International 2004 (C:MDI Training Pubic EconomicsREVISIONS 2004 Marwa\BCONOMIC DOC Ver 06iM[D]T) Ree eee Project Economics & Decision Making . the political infrastructure of the territory where the investment opportunity exists . policy towards energy investment + policy towards foreign investment + conditions attached to investment + past performance of governments in energy sector + fature outlook for government intervention or encouragement of petroleum exploitation political stability + policy towards the environment ‘© ownership of infrastructure may mean that a project is more profitable for some partners than others, e.g. the owners of a pipeline receive tariff income Project Economics & Decision Making 6 MDI International 2004 (CMI Training Pubic Economics REVISIONS 2004 8fanuall ECONOMIC DOC Ver 06Project Economics & Decision Making Accountants' vs Economists’ View of Financial Decisions The traditional view of the accountant would suggest that decisions based on accounting data are influenced by the profit earned from an investment or expenditure proposal. For example, a decision whether to develop a petroleum reservoir would depend on the profits (or losses) that are generated over the life of the field. What, if any, are the limitations of such an approach? is it always worthwhile as long as profits are generated? how do you know whether the absolute amount of profit is worthwhile? does it matter if the profit is generated over, say, 10 years or 20 years? given that accounting profits deal with non-cash expenditures, is this the best way of assessing commercial opportunities? The economists’ emphasis is on identifying the cash flows, as opposed to the accountants’ profits, that arise from investment proposals and "discounting" these cash flows in recognition of the fact that money today is worth more than money tomorrow. The next sections concentrate on this approach and explain concepts such as the time value of money and discounted cash flows. Project Economics & Decision Making 7 ©MDT International 2004 (C:AMDY Training Public Economies REVISIONS 20048fanual ECONOMIC.DOC Ver 06eee Project Economics & Decision Making Accountant’s Rate of Return Definition ‘A common definition of the accountant's rate of return (ARR) is to express the average profit of a project as a percentage of the average investment. The average profit is calculated by taking the total profits earned on the investment over the whole of its life and dividing by the number of years of the project. The average investment is calculated by taking half the original investment on the basis that it will be wholly depreciated by the end of its useful life. AVERAGE PROFIT AVERAGE INVESTMENT wee for averncerront = TSTALIRGeTE Dee ARR % = AVERAGE MvesT¥ENT = MITALINVESTIENT ~~ Criteria for Decision Making So, how do you know whether the answer obtained is good or bad? This is done by comparing the percentage answer from the above formula with a predetermined required rate. The required rate is normally no smaller than the company’s Cost of Capital and may be larger (see later section, page 19, for a definition of the Cost of Capital), * _ IfARR > Cost of Capital, then investment is accepted, © IEARR < Cost of Capital, then investment is rejected ‘© Where there is a choice between projects, choose the project with the highest ARR in excess of the Cost of Capital ‘Tum the page for a worked example. Project Economics & Decision Making 8 ©MDT International 2004 (C:MDI Trainin Public conomiesREVISIONS 2004 Manual ECONOMIC DOC Ver 06Project Economics & Decision Making OOO pian O EXAMPLE - ACCOUNTANT'S RATE OF RETURN ‘New Oil Company has one remaining well slot on its Clam Platform and is considering drilling a well to one of three different target locations, A, B or C. Each well has a profit (income less cost) as profiled in the following table. All the potential investments take place in Year 0 and all the well options start to generate income at the beginning of Year | Year Well A Well B Well C $ $s $ 0 -2,000,000 — -2,400,000—-2,400,000 1 +500,000 +1,000,000 +700,000 2 +500,000 +900,000 800,000 3 +500,000 +800,000 +900,000 4 +500,000 700,000 —-+1,000,000 5 +500,000 - ‘ 6 +500,000 - - Total Profit +1,000,000 —+1,000,000-—-+1,000,000 Average profit $166,666 $250,000 $250,000 Average investment $1,000,000 $1,200,000 $1,200,000 Rate of Return 17% pa 21% pa 21% pa Critique of ARR Method A superficial analysis of the above figures would suggest that Well A is inferior to Wells B and C. However, this takes no account of the fact that Well A will yield a return of 17% over 6 years whereas Wells B and C yield their return over a shorter four year period. Wells B and C would appear to be equally attractive. However, closer examination reveals that more of Well B's profits are earned in the earlier years than Well C. A weakness of this method, then, is that no account is taken of the timing of the profits Project Economics & Decision Making 9 ©MDT International 2004 (C:\MDT Training Public Economics REVISIONS 2004ManuallCONOMIC DOC Ver 06OOO ee nee Project Economics & Decision Making The Cash Flow Stream We saw in the previous example that the ARR deals with the measurement of profit and not the measurement of cash flows. Profit in a period is measured by taking into account cash that was spent in previous years (depreciation) and cash that we plan to spend in future years (provision for site restoration). The economist’s investment appraisal methods only take account of investment cash flows, both negative and positive. It is therefore vital to identify the relevant cash flows for a particular project At their broadest level, the types of cash flow that are generated over the life of a producing hydrocarbon field are summarised in the following diagram: oh 2a} 1 cas’ Tes 12345 6 7 @ 9 1041 12 19 14 15 16 17 18 19 20 10} pecommissionKe EXPL'N — CONST'N PRODUCTION Year A key component of investment appraisal is gathering the relevant data and establishing assumptions that will apply. The data required to evaluate the development of a new oil field might consist of: + the total recoverable reserves from the field + this will normally be calculated by reservoir/petroleum engineers based on data obtained from exploration and evaluation drilling + the estimate will be prone to uncertainty + an estimate of the timing of recovery of the reserves and the rate of recovery, i.e. a production profile for the life of the field + this will normally be calculated by reservoir/petroleum engineers based on information and assumptions on: Project Economics & Decision Making 10 MDI International 2004 (CAMDP Training\PublicconomiceREVISIONS 2004\Manual\2CONOMIC DOC Ver 06iM] Dy T) Ws ean Project Economics & Decision Making — total recoverable reserves — the properties of the petroleum in place, e.g. light or heavy, sweet or sour crude — process capacities, e.g. oil, water, gas, injection — timing of drilling development wells + the price to be expected from the sale of the products of the field + Some companies use Brent as the basic oil price assumption and estimate differentials according to specific qualities of other crudes + the level of capital expenditure (Capex) required to develop the field and the timing of the expenditure + this will be influenced by the development method and strategy + Capex is normally divided into Wells and Facilities as these two categories receive different tax treatments + the estimate is capable of reasonable levels of accuracy given the historical experience and data built up within the industry + the level of operating costs (Opex) + this will be influenced by factors such as = location - the type of structure — manning levels — operator’ allocation of indirect costs — maintenance philosophy and policy + Opex is classified as: = Variable Opex - costs that vary according to production output, eg, transportation tariffs - Fixed Opex - the cost of operating the production facility, insurance and the operator’s G&A costs + lease payments are treated as Opex - specific treatment is covered in one of the case studies later in the training course + the estimate is capable of reasonable levels of accuracy given the historical experience and data built up within the industry Dae gmnnrrioy* CAP + abandoitinent costs 9 ho — 22 Y, ex) + these will be influenced by methods of suitable field abandonment permitted by the regulating authorities + assumptions on the tax structure and rates of taxation . these are likely to be modelled around existing tax structures and rates with sensitivities performed for changes to tax rates Project Economics & Decision Making i ©MDT Imernational 2004 (C-IMDI Trainng\ Public conomics\ REVISIONS 2004 Manual ECONOMIC.DOC Ver 05Project Economics & Decision Making . exchange rates + assumptions will be made as to future exchange rates for goods and services which are normally procured and sold in other than the ‘company's normal currency of transacting business + no great certainty can be attached to future exchange rates and sensitivities will normally be performed for variations in exchange rates + the cost of capital + this is the minimum rate of return a company and its investors might wish to achieve from an investment proposal + it is influenced by what the company can earn from its money by investing it elsewhere Project Economics & Decision Making 22 ©MDT International 2004 (C:IMD1 Training\Pubic\oonomics REVISIONS 2004ManuallSCONOMIC DOC Ver 06iM] DIT) Deanne Project Economics & Decision Making Payback Period Method The method of measuring how long it takes to repay an investment decision is a common, and straightforward, way of making investment decisions. Organisations set finite time periods within which the original investment must be repaid. The calculation of the actual payback period is the point in time when the cumulative cash flow (undiscounted) from the investment has reached zero. Investment Decision Criteria ‘* If the period is shorter than the payback period set by the organisation, then the investment is accepted. © If the payback period is longer than the payback period set by the organisation, then the investment is rejected. * Where there is a choice of projects, choose the project with the shortest payback period less than the required payback O EXAMPLE - PAYBACK PERIOD New Oil Company is considering whether to drill an additional development well on its Clam Field. The well will cost $2,000,000 and will generate $500,000 p.a. of additional revenue for 6 years. The company requires that investments are paid back within three years. Should the investment go ahead? Calculation of the payback period is as follows: ‘Annual Cumulative Year___Cash Flow Cash Flow $ $ 0 2,000,000 -2,000,000 1 +500,000 -1,500,000 2 +500,000 -1,000,000 3 +500,000 500,000 4 +500,000 0 5 +500,000 +500,000 6 +500,000___+1,000,000 —8&__ 500,000 __+1,000,000 ‘The payback period for the above project is, therefore, four years. Based on a requirement that investments pay back within three years, this investment would be rejected. ed Project Economics & Decision Making B ©MDT International 2004 (C:MDT Training Public Economics REVISIONS 2004 Manual ECONOMIC DOC Ver 06Project Economics & Decision Making Critique of Payback Period Method ‘The attraction of this method is its relative simplicity. It is a very common investment criterion in industries outside the oil and gas sector. The danger of the method stems from the same simplicity and that it takes no account of the absolute investment values nor of total and future cash flows beyond the payback period. The exercise on payback illustrates this point (see separate chapter, Exercises), Some companies use the Payback, or Payout, method as a measure of this particular aspect of commercial risk and not as an absolute project selection criterion. A longer payback period may be acceptable for projects which have lower perceived risk in other respects. This will be discussed further in the separate section dealing with uncertainty and risk (see page 52). Project Economics & Decision Making 77 ©MDT International 2004 (C-MMD raimig\Publ\ Economics REVISIONS 2004 Manuall2CONOMIC DOC Ver 06iM{D]T) ena L Project Economics & Decision Making Present Value Concept - the Time Value of Money ‘The aggregation of annual cash flows arising from an investment opportunity results in an overall positive or negative cash flow over the life of the investment. Basing decisions on this answer does not recognise the time value of money - that money today is worth more than money tomorrow. A technique exists to equate future annual cash flows to today's value or Net Present Value (NPV). This technique is known as discounting, ‘The technique gives an answer to the following type of question: 1 Would you rather receive $10,000 now or $12,000 in four annual instalments of $3,000? 2. Would you rather receive $10,000 in the following instalments: . $6,000 after 1 year and $4,000 after 2 years or $12,000 in the following instalments: . $2,000 after 1 year followed by five further instalments of $2,000 at yearly intervals? 3. Which would you prefer if all four options were available? The answer to the questions is going to be influenced by what you might do with the money if you had it today rather than tomorrow, viz. you have an opportunity to invest it and ear interest. For example, if we invest $10,000 today at an annual rate of interest of 10%, after one year our investment is worth: $10,000 + ($10,000 x 0.10) = $11,000 This can also be stated as: $10,000 x (1 + 0.10) = $11,000 At the end of the second year our investment is worth $11,000 + ($111,000 x 0.10) = $12,100 This can also be stated as: $10,000 x (1 + 0.10)2 = $12,100 Expressed arithmetically, the future value of our $10,000 investment at 10% annual compound interest is: Project Economics & Decision Making 15 ©MDT International 2004 (C:AMDT Training’ Pubic conomicsREVISIONS 2004\Manual\ECONOMIC DOC Ver 06000 eben Project Economics & Decision Making FV=10 +i)" where FV = Future Value I= Original Investment Discount Rate Number of Years Invested n ‘The present value of future amounts can be expressed as: I=FV( +i) where I is also the Present Value, or today’s value in future $'s. ‘The present value equation translates into a table of discount rates according to the number of years and the discount rate used. Applying these discount factors, we can now attempt to answer the questions posed earlier. O EXAMPLE - DISCOUNT FACTORS TABLE PRESENT VALUE OF 1 Discount Rate Years 5% 10% 15% 20% 0 1.000 1.000 1.000 1.000 1 0.952 0.909 0.870 0.833 2 0.907 0.826 0.756 0.694 3 0.864 0.751 0.658 0.579 4 0.823 0.683 0.572 0.482 5 0.784 0.621 0.497 0.402 6 0.746 0.564 0.432 0.335 7 0.71 0.513 0.376 0.279 8 0.677 0.467 0.327 0.233 9 0.645 0.424 0.284 0.194 10 0.614 0.386 0.247 0.162 rT 0.585 0.350 0.215 0.135 12 0.557 0.319 0.187 0.112 1B 0.530 0.290 0.163 0.093 14 0.505 0.263 0.141 0.078 15 0.481 0.239 0.123 0.065 16 0.458 0.218 0.107 0.054 17 0.436 0.198 0.093 0.045 18 0.416 0.180 0.081 0.038 19 0.396 0.164 0.070 0.031 20 0.377 0.149 0.061 0.026 Project Economics & Decision Making 16 MDT International 2004 (C-MDT Trainin Pubic conomics REVISIONS 2604\ManuallBCONOMIC DOC Ver 067 iM[D TT) Raa ean Project Economics & Decision Making O EXAMPLE - PRESENT VALUES 1. Would you rather receive $10,000 now or $12,000 in four annual instalments of $3,000? _____ CASH LOW Year Discount Rate Undiscounted Discounted Undiscounted Discounted @10% 0 1.000 $10,000 $10,000 $3,000 $3,000 1 0.909 0 0 $3,000 $2,727 _ 2 0.826 0 0 $3,000 $2,478 7 0.751 0 0 $3,000 $2,253 Total $10,000 $10,000 $12,000 $10,458 In this example, it is preferable to receive $12,000 as four annual instalments of $3,000 as the present value of this cash flow is $10,458 as opposed to the present value of $10,000. 2. Would you rather receive $10,000 in the following instalments: + $6,000 after 1 year and $4,000 after 2 years or $12,000 in the following instalments: . $2,000 after 1 year followed by five further instalments of $2,000 at yearly intervals? CASH FLOW Year Discount Rate Undiscounted Discounted Undiscounted Discounted @10% 0 1,000 i) 0 i) 0 1 0.909 $6,000 $5,454 $2,000 $1,818 7 0.826 $4,000 $3,304 $2,000 $1,652 3 0.751 oO 0 $2,000 $1,502 4 0.683 0 0 $2,000 $1,366 5 0.621 0 oO $2,000 $1,242 6 0.564 0 oO $2,000 $1,128 Total $10,000 $8,758 $12,000 $8,708 Project Economics & Decision Making 7 ©MDT International 2004 CAMDT Traiing\Pub ie Beonomics REVISIONS 2004 Manual ECONOMIC DOC Ver 06eee Project Economics & Decision Making In this example, it is preferable to receive $10,000 in two instalments as this has a present value of $8,758 as opposed to the present value of $8,708 from six instalments of $2,000. 3. Which of all the alternatives is most attractive? ‘The preferred option of the four alternatives is the one that has the highest present value, viz. ‘$12,000 in four annual instalments of $3,000. Project Economics & Decision Making 18 ©MDT International 2004 (C/MDI Training Public Zconomics REVISIONS 20041ManuallECONOMIC.DOC Ver 06Project Economics & Decision Making The Cost of Capital What discount factor should we use when evaluating investment opportunities? The discount factor used by a business reflects the organisation’s weighted average cost of capital. The weighted average cost of capital represents the average cost of different sources of finance available to the business. These sources of finance might be: * bank loans * lease arrangements © share capital Each of these sources of capital has a cost attached to it. The cost to the business is the interest rate payable on the capital by the business to the provider of the capital Different sources of capital have different interest rates, or costs, associated with them. The different interest rates reflect the different levels of risk taken by the source of capital. For example, a bank loan may be obtained at a rate of interest of 6% p.a. as Jong as the business provides security over the value of the loan in order to reduce the bank’s risk. A leasing company may provide finance at an interest rate of 8% p.a. and require partial security over the finance. Shareholders may be looking for a return of 15% p.a. or more - this source of finance is more expensive as sharcholders have a higher expectation of return on their capital as they have no security over their capital. Companies can calculate the weighted average cost of different sources of capital. This weighted average cost becomes the discount factor that is used in business calculations of Net Present Value. It represents the rate of return that must be achieved in order to at least satisfy the needs of providers of capital to the company. All sources of capital are pooled when evaluating the economics of an investment opportunity. In the illustration below, the company’s cost of capital is 10%. Even if the company negotiated a bank loan at 6% p.a. in order to finance a new field development, the opportunity would be appraised using the company’s weighted average cost of capital of 10%. If it failed to do this, the company might fail to meet the expectations of all providers of capital, particularly the shareholders. Project Economics & Decision Making Dv ©MDT International 2004 (C-IMDT Training\Publi\ Economics REVISIONS 2004 ManvallSCONOMIC.DOC Ver 06The Cost of Equity The cost to the company of loans and leases is normally easy to identify as there will be agreements in place with various lenders which will stipulate the interest rate. However, the cost of equity may not be so easily identified. There are two schools of thought on the derivation of the cost of equity: . The Dividend Yield Growth or P/E Growth Model * The Capital Asset Pricing Model The P/E Growth Model The chapter on Understanding Financial Information in the Counting the Cost training programme manual defined Price/Earnings ratio as Market Price of Share = Earnings per Share. We can invert this expression to work out the fraction, or percentage, that Earnings per Share is to Market Price of Share. To this we can add the desired growth rate- Cost of Equity = Eanings per Share + Growth Rate Share Price A share with a P/E ratio of 15 and a growth rate of 3% would have a cost of 100/15 = 6.7% + 3% =9.7%, Project Economics & Decision Making 20 ©MDT international 2004 (CAMDT Trainin Puble\Bconomis REVISIONS 2004 MansalECONOMIC DOC Ver 06iM[D]T) Rae arene Project Economics & Decision Making The Capital Asset Pricing (CAPM) Model The CAPM model states that the cost of equity capital is a function of the risk free return on, say, a government bond plus a risk adjusted premium for the share. The risk premium is derived from the market rate of interest and the beia of the stock. The beta of a share measures its price volatility relative to a general or industry specific index. Ifa share tends to follow the ups and downs of all other stocks at the same time, it is said to have a beta of 1. If it rises and falls more than other shares, it is said to have a beta > 1, We can consolidate this in the following expression: CEC =Rf+ B(Mi- Rf) where CEC = Cost of Equity Capital Rf — = Risk free rate of return B Beta of the investment Mi = Market rate of Interest For example: CEC =7% +1,5(10% - 7%) =MH+ 4.5% = 11.5% Project Economics & Decision Making 2 ©MDT International 2004 (C/UDE Training Pubic Economies REVISIONS 2004\Manual ECONOMIC DOC Ver 06iM] D]T) eee Project Economics & Decision Making Net Present Value Method So, how do we apply the above concept for making decisions in an industrial, or petroleum industry, setting? The key to the technique is identifying the cash flows that, arise from an investment proposal and discounting these cash flows. The discount factor chosen will represent the company's required rate of return on the project. Investment Decision Criteria ‘The Net Present Value (NPV) method uses the following criteria for decision making: © Ifthe NPV = 0, then the project may be accepted. © Ifthe NPV <0, then the project is rejected © Where there is a choice of more than one project, the project with the highest NPV may be chosen. O EXAMPLE - NET PRESENT VALUE New Oil Company is debating whether to drill an additional development well on its Clam Field. The cost of drilling the well has been estimated at $15,000,000. The incremental revenues that will result are estimated to be $6,000,000 in the first four years, $4,000,000 in Year 5 and $2,000,000 in Year 6. The company's cost of capital is 20%. Should the well be drilled? (CASH FLO’ Year Discount — Undiscounted Factor @ 20% 0 1.000 -$15,000,000 $15,000,000 1 0.833 $6,000,000 $4,998,000 2 0.694 $6,000,000 $4,164,000 3 0.579 $6,000,000 $3,474,000 4 0.482 $6,000,000 $2,892,000 5 0.402 $4,000,000 $1,608,000 6 0.335 ‘$2,000,000 $670,000 Total $15,000,000 $2,806,000 ‘The above tabulation yields a NPV of $2,806,000 at a discount rate of 20%. This would suggest that the project is viable. Project Economics & Decision Making 22 MDT International 2004 (CMD Training Pubi\ Economics REVISIONS 2004\Manwal2CONOMIC.DOC Ver 06iM] D IT) contents Project Economics & Decision Making Critique of NPV Method The method would appear to be superior to the ARR and undiscounted Payback methods as it recognises that the value of cash tomorrow is different than the value of cash today. It potentially offers a more reliable method of comparing project proposals where choices have to be made and where the cash flow streams are different in timing and amount. Project Economics & Decision Making 23 ©MDT International 2004 (CAMDT Training Publi Economics REVISIONS 2004 ManwaNECONOMIC.DOC Ver 06Project Economics & Decision Making Discounted Payback Period Method Now that we have introduced the concept of the time value of money, we can apply the discounting technique to the payback period method. This is simply done by discounting a cash flow to determine the point at which the cumulative discounted cash flow = zero. This is illustrated in the example below, which is based on the previous payback period example found on page 13. O EXAMPLE - DISCOUNTED PAYBACK PERIOD ‘New Oil Company is considering whether to drill an additional development well on its Clam Field. The well will cost $2,000,000 and will generate $500,000 of additional revenue each year for 6 years. The company requires that investments are paid back within four years on a discounted basis. The company’s cost of capital is 10%. Should the investment go ahead? Calculation of the discounted payback period is as follows: UNDISCOUNTED DISCOUNTED ‘Annual ‘Cumulative Cash ‘Annual ‘Cumulative Year Cash Flow Flow Cash Flow ___Cash Flow $ $ $ $ 0 -2,000,000 -2,000,000 2,000,000 2,000,000 1 +500,000 -1,500,000 +454,500 1,545,500 2 +500,000 -1,000,000 +413,000 -1,132,500 3 +500,000 ~500,000 +375,500 -757,000 4 +500,000 0 +341,500 -415,500 5 +500,000 +500,000 +310,500 -105,000 6 +500,000 +1,000,000 +282,000 +177,000 The discounted payback period for the above project is greater than 5 years, Based on a requirement that investments pay back within four years, this investment would be rejected. Critique of Discounted Payback Method The above example illustrates that the payback period is longer when the time value of money is taken into account. It is more realistic to take account of the time value of money when calculating the payback period. However, the same disadvantages as noted on page 14 still apply. Project Economics & Decision Making 24 ©MDI International 2004 (CAMDP Training Pubic Economies REVISIONS 2004 Sfanual|ECONOMIC DOC Ver 06Project Economics & Decision Making Internal Rate of Return Method Definition Often businesses require to know what rate of return their investment will yield. The Internal Rate of Return (IRR) method is to determine the discount rate required to yield a Net Present Value of 0. This can be illustrated in the following example. O EXAMPLE - INTERNAL RATE OF RETURN Let us take the following example and discount the cash flow stream at a rate of 30% p.a. CASH FLOW Year Discount — Undiscounted iscounted Factor @ 30% 0 1,000 -$15,000,000 _-$15,000,000 1 0.769 $6,000,000 $4,614,000 2 0.592 $6,000,000 $3,552,000 3 0.455 $6,000,000 $2,730,000 4 0.350 $6,000,000 $2,100,000 5 0.269 $4,000,000 $1,076,000 6 0.207 $2,000,000 $414,000 Total $15,000,000 -$514,000 This shows that, at a discount rate of 30%, the project has a NPV <0 and should therefore be rejected. This begs the question - at what discount rate is the NPV neither > 0 nor <0, ie. at ‘what discount rate is the NPV = 0? This can be answered through a process of iteration: Discount Rate NPV % $ 20 42,806,000 21 42,422,000 22 +2,050,000 2B +1,686,000 24 +1,344,000 25 “+1,008,000 26 +686,000 21 +362,000 28 +64,000 29 -228,000 30 -514,000 Project Economics & Decision Making 25 ©MDT International 2004 (CAMDT Training Pubit\ Economies REVISIONS 2004\ManwalBCONOMIC:DOC Ver 06Project Economics & Decision Making The above table shows that the NPV changes from +ve to -ve at a discount rate between 28% and 29%. The value can be calculated reasonably accurately by interpolation: 28% + { 64,000, x (29% ~ 28%)} = 28.2% 64,000 + 228,000 IRR Criteria for Decision Making The following rules can be applied when using the IRR method: * Ifthe IRR > the Cost of Capital, the investment proposal may be accepted. ‘* Ifthe IRR 1, the investment should be accepted. . IfPI< 1, the investment should be rejected. . Where there is a choice between alternative investments, choose the option with the highest PI in excess of 1. Project Economics & Decision Making 28 ©MDT International 2004 (C:AMDI Training Pubic Economics REVISIONS 2004 Manual ECONOMIC.DOC Ver 06000 nee Project Economics & Decision Making O EXAMPLE - PROFITABILITY INDEX ‘New Oil Company is debating whether to install improved oil/water separation equipment on its Clam Field. The capital cost of the equipment has been estimated at $15,000,000. The incremental revenues that will result are estimated to be $6,000,000 in the first four years, $4,000,000 in Year 5 and $2,000,000 in Year 6. The company's cost of capital is 20%. What is the profitability index of this proposal? ___ CASHFLOW Year Discount — Undiscounted Discounted Factor @ 20% 0 1.000 —-$15,000,000 —_-$15,000,000 1 0.833, $6,000,000 $4,998,000 2 0,694 $6,000,000 $4,164,000 3 0.579 $6,000,000 $3,474,000 4 0.482 $6,000,000 $2,892,000 a 0.402 $4,000,000 $1,608,000 6 0.335 $2,000,000 $670,000 Total $15,000,000 $2,806,000 PI= $2,806,000 +1 = 1.187 $15,000,000 Critique of PI Method A potential strength of the PI method is that it is a relative measure - it is measuring the NPV of what you get out compared to the NPV of what you have to put in. It is an input-output relative measure unlike NPV which is an absolute measure, Just because a project has a positive NPV does not have to make it an efficient way to spend a company’s money. We will demonstrate this more clearly later when we come to ‘compare project economics and to rank different project alternatives, A potential weakness of the measure is that it will generally favour projects with a low initial investment (or low “denominator”). This may be at the sacrifice of NPV. Project Economics & Decision Making 29 ©MDT International 2004 (C\MDI Traiming\ Public Economies REVISIONS 2004\MamualBCONOMIC DOC Ver 06Project Economics & Decision Making NPV/Max Exposure im[D]T) INTERNATIONAL NPV/Max Exposure measures the NPV generated by a project in relation to its cumulative, undiscounted cash flow. The point of Maximum Exposure, the point of maximum negative cumulative cash flow, is also the point at which the anmual cash flows tum from negative to positive (see the example below). NPV/Max Exposure is, the ranking criterion when the company is cash flow constrained. Using NPV/Max Exposure maximises the NPV per $ of cash flow (using PI maximises NPV per $ of Capex or of Capex plus Opex). The indicator is calculated as follows: NPV/Max Exposure 7 NPY of Investment ‘Maximum Negative Cumulative Cash Flow EXAMPLE - NPV/MAX EXPOSURE A satellite field development proposal has the following revenue and expenditure streams: Undiscounted Cash Flows (S000) ‘Year "Revenue Capex Opex Total Cost Cash Flow Cumulative Discount Rate NPV Cash Flow @10% 0 “16,168 “16168 16,168 —=16, 168 1.000 -16,168 1 65,162 65,162 65,162 81,330 0.909 -73,929 2 56879 15,943 -12,422 28,365 28,514 52,816 0.826 23,553 3 67,671 -13,754 -16,045 —-29,799 «37872 -14, 944 0.751 28,442 4 62,719 0 12.717 12.717 50,002 35,058 0.683 34,151 5 40,345 0 9327-93327 31,018 66,076 0.621 19,262 6 16,207 0 4127 4127 12,080 78,136 0.564 6,813 7 9.473 0 2m 271 6,762 84,918 0513 3,469 Set 48 0 +1605 -1,605 5819 90,737 0467 2,717 Total 260,718 -111,027 -58,954 169,981 90,737 43,007 NPV/Max Exposure= $43,007 = 0.53 $81,330 SS Project Economies & Decision Making ©MDT International 2004 30 CC-IMDT Training\Pub ie onomics\ REVISIONS 2004\ManuallECONOMIC.DOC Ver 06Project Economics & Decision Making Critique of NPV/MaxExp Method The result of 0.53 above is in absolute terms a relatively meaningless figure. NPV/Max Exposure tends to be used for comparative purposes where there is a choice between alternative projects. The higher the ratio, the better the project. It is also a reasonable indicator of the relative risk attached to a project. For example it is possible to have two projects with the same NPV but with different NPV/Max Exposure ratios. It would generally be preferable to choose the project with the higher NPV/Max Exposure as less money is put at risk to achieve the same overall result. PI and NPV/Max Exposure are closely related but they do not always give the same ranking. For example, a phased development might have high Capex but relatively low ‘Max Exposure where early production provides revenue to cover some of the early Capex. Such a project would have a higher ranking in terms of NPV/Max Exposure than under the PI criterion. Max Exposure also takes account of Opex, which might be excluded from the calculation of PI. Projects with high Opex would tend to have a higher ranking under the version of PI which only considers Capex than under NPV/Max Exposure. Project Economies & Decision Making 31 ©MDT International 2004 (C:MDI Training Public Economics REVISIONS 200¢\Manwal\BCONOMIC DOC Ver 05imp} T) Coats Project Economics & Decision Making Methods Compared We have now examined the following methods of making investment decisions: . Accountant's Rate of Return © Payback Period . Net Present Value . Internal Rate of Return © Profitability Index . NPV/Max Exposure ‘We will now compare these methods with a view to establishing whether one method is superior to another and whether they yield consistent conclusions. This is best illustrated in the example overleaf. We will then go on to consider how investment decisions can be made when there are limits to the amount of investment funds available to an organisation - capital rationing. The Accountant's Rate of Return method would suggest that Project A is the best project. This is because the average profit per year is more than in the other two Projects. The Payback Period method would suggest that Project B is the best because it achieves payback in the shortest time. However, it does ignore the impact of cash flows after Year 3 Not surprisingly, all methods that rely on discounting of cash flows yield consistent ranking answers. In the next section, we will examine how investment decisions might be made where there are choices available that are constrained by the amount of investment funds available to the organisation. Project Economics & Decision Making 32 ©MDT International 2004 (C-\MDT Trainng\Pubt\EconomsIREVISIONS 2004\ManuallCONOMIC DOC Ver 06Project Economics & Decision Making O EXAMPLE - COMPARISON OF APPRAISAL METHODS New Oil Company has the following investment alternatives available for three projects, each requiring an initial investment of $2,000,000. The projects have different cash flow streams associated with them as illustrated below. The results of the above investment criteria are summarised for each project. Year Project A Project B Project C $ $ $ 0 =2,000,000 2,000,000 —_-2,000,000 1 +200,000 +800,000 +600,000 2 +400,000 +600,000 +600,000 3 +600,000 +600,000 +600,000 4 +600,000 +400,000 +600,000 5 +600,000 0 +400,000 6 +680,000 0 +200,000 Total +1,080,000 +400,000 —-+1,000,000 Accountant's Rate of Return 18% 10% 16.7% (Ranking A CB) Payback Period 43 years 3 years 3.3 years (Ranking B C A) NPV @ 12% $8,840 -$125,800 _+$151,000 (Ranking C AB) Internal Rate of Return 12% 8.5% 15% (Ranking C AB) Profitability Index 0,996 0.937 1.075 (Ranking C AB) ‘NPV/Max Exposure -0.01 -0.06 0.08 (Ranking C AB) Project Economics & Decision Making 33 MDT International 2004 (C:\MDT Training\Publt\Eoonomics REVISIONS 2004\MamuallSCONOMIC DOC Ver 05OOO Ree ace Project Economics & Decision Making Decision Making Under Capital Rationing In the real world it is unlikely that an organisation will have access to unlimited funds for investment purposes. Capital is normally a finite resource and has to be rationed for purposes that are likely to generate the best yields. This section deals with how investment decisions might be made where there is such a finite amount of capital investment funds available This is best illustrated by the scenario in the following example. O EXAMPLE - DECISIONS UNDER CAPITAL RATIONING New Oil Company is in the process of preparing its capital investment budget for the year 20xx. A number of investment proposals have been put forward for inclusion in the budget - Projects A - E, Individually, all of these projects are viable at the company's cost of capital (15%). Cash flows, NPV, IRR and PI for each project is shown in the table below. In total, the projects would require an investment of $39,000,000, However, other financial planning exercises reveal that the company will only have available $19,000,000 for capital investment purposes over the life of these projects. Which projects should New Oil Company include in its budget for 20xx? Project Year A B Cc D E $ $s $ $ $ 0 10,000,000 -12,000,000 -5,000,000 _-9,000,000 __-3,000,000 1 +6,944,000 +3,840,000 +1,710,000 +3,610,000 _—_+1,090,000 2 +6,944,000 +3,840,000-+1,710,000+3,610,000 -—_+1,090,000 3 - +3,840,000 +1,710,000#3,610,000 —_+1,090,000 4 - 43,840,000 +1,710,000 +3,610,000— +1,090,000 5 - 43,840,000 +1,710,000 = +1,090,000 NPV@15% — +1,290,900 —-#871,700 —-+731,900+1,306,600—-+653,700 IRR 25% 18% 21% 22% 24% PI 1.129 1.073 1.146 1.145 1.218 The ranking of the above projects is as follows: Ranking Method Ranking Order NPV @ 15% DABCE IRR AEDCB PI ECDAB El Project Economics & Decision Making 34 ©MDT International 2004 (CIMDI Training\Publie\Beonomies REVISIONS 2004 Manual ECONOMIC.DOC Ver 05:imp] T) Ruse oe Project Economics & Decision Making The suggested approach to arrive at a solution to this scenario is to base the decision on the Profitability Index. The higher the index, the more cash that is eared for every pound, after deducting interest for the waiting time of the company's capital. In a capital rationing situation, funds are, therefore, allocated to projects starting with the highest profitability index first until the capital funds are allocated or until the PI value of 1.000 is reached. Applying this method to the above scenario, New Oil Company would commit to Projects E, C, and D in its budget for 19x. We can prove the validity of this method by comparing the aggregate NPVs of the alternative investment criteria TS O EXAMPLE - COMPARISON OF NPVs The following table shows the impact of allocating the total available investment amount of $19,000,000 to projects according to the rankings that arise from each appraisal method. Ranking by NPV Ranking by IRR Ranking by PI Outlay “NPV Outlay NPV Outlay NPV $m $m $m Sm $m $m D 9,000 1.306 A 10.000 1.291 E 3.000 0.654 A 10,000 1.291 E 3.000 0.654 C 5.000 0.732 B - - D D 9.000 1.306 c - - C 5.000 0.732 A E - - B - - B Total 19.000 2.597 18.000 2.677 17.000 2.693 The table shows that the highest aggregate NPV is achieved by allocating capital according to the ranking arising from the Profitability Index. In fact more value is created from a lower amount of capital! Project Economics & Decision Making 35 ©MDT International 2004 CC-IMDI Training\Pub ie Beonomis\REVISIONS 2004\MamualBCONOMIC DOC Ver 06iM] DIT) Project Economics & Decision Making The Impact of Rising Prices and Inflation All our examples and exercises so far have assumed that prices and the general level of inflation remain constant over the life of our projects. We shall now consider how to take account of rising prices and general inflation within our discounted cash flow decision models. The model we advocate is summarised in the following diagram. CONSTANT PRICES/COSTS J Build in Escalation MONEY OF THE DAY (MOD) | Strip out Inflation REAL TERMS ‘The diagram shows that a cash flow estimate is initially prepared at constant prices and costs prevailing as at the time of the estimate. To this base level we can apply any specific price or cost escalation that is anticipated to individual line items in our forecast. This level of price/cost is referred to as Money of the Day (MOD). The final step is to take account of inflation. We shall define inflation as the eroding value of the purchasing power of your currency. It is different than price/cost escalation in that it applies across the board to all line items in a cash flow model. The resultant price/cost level is referred to as Real ‘Terms and is normally the level at which project economics are conducted. You should note that economists typically construct future cash flow models in Real ‘Terms whereas accountants prepare financial forecasts in Money of the Day ‘A summary of the above definitions is as follows Escalation = changes to prices and costs specific to items within the project Inflation = the change (usually falling) in the purchasing power of our currency We shall now illustrate this by looking at the following example. Project Economics & Decision Making 36 ©MDT International 2004 CCAMDT Training\Publc\Economics\REVISIONS 2004\ManualSCONOMIC DOC Ver 06.cu Project Economics & Decision Making O EXAMPLE - RISING COSTS ‘Your company is planning to install a new computer system with a capital cost of $10,000 as a result of a new contract the company has been awarded. The sales revenue generated by the contract will be $10,000 p.a. for 5 years. The incremental costs associated with the contract have been estimated at $5,000 p.a. and you estimate that these costs will rise by 10% p.a. The company’s cost of capital is 18%. First we will examine the viability of the project taking account of the above specific price rises but ignoring general inflation. Year Sales Costs fet Cash Discount Present Flow Factor Value s s $ @18% s 0 10,000 10,000 1.000 10,000 1 10,000 5,000 5,000 0.847 44,235, 2 10,000 5,500 4,500 0.718 43,231 3 10,000 6,050 3,950 0.609 +2,406 4 10,000 6,655 3,345 0.516 +1,726 5 10,000 7,320 2,680 0.437 +1171 TOTAL 42,769 ‘The NPV of the project is +$2,769, indicating that the project is viable ‘An essential feature of the cash flows in the above example is that they have a constant purchasing power in the market place. However, if we add general inflation to the equation, a future $ is worth even less to us in terms of current purchasing power. We must, therefore, additionally discount the cash flows to take account of the declining value of our currency through time. The following example illustrates this by taking the figures from the previous example and assuming general inflation, Project Economics & Decision Making 37 ©MDT International 2004 (C:\MDI Training! Public EconomicsREVISIONS 200\Manual\BCONOMICDOC Ver 05Te Project Economics & Decision Making O EXAMPLE - INFLATION ADJUSTED DCF This example is a continuation of the previous example on page 38. We will now assume that general inflation is forecast to be 12% p.a. over the life of the project. We can take the undiscounted net cash flows from the previous example and convert these to the real purchasing power of our currency at the beginning of the project. To achieve this, we will “deflate” our future cash flows by a discount factor for 12%, Year =‘ Net Cash Deflator Adjusted Discount Present Flow Net Cash Factor Value $ Flow $ @18% 8 0 10,000 1,000 =10,000 1.000 10,000 1 5,000 0.893 4,465 0.847 +3,782 2 4,500 0.797 3,587 0.718 42,575 3 3,950 0.712 2,812 0.609 41,713 4 3,345 0.636 2,127 0.516 +1,098 5 2,680 0.567 1,520 0.437 +664 TOTAL -168 The effect of general inflation has been to change our previous positive NPV into a negative NPV indicating that the project is not viable under inflationary conditions of 12% p.a. Note: The same result could have been achieved by using a single “discount” factor that takes account of both inflation and the cost of capital. The equivalent factor would have been 32.16% (18% + 12% compounded), SS What we must do, therefore, is to establish price and cost rises that are specific to our project and to establish our view of the general inflationary impact on the purchasing power of our currency at today’s prices. Project Economics & Decision Making 38 ©MDT International 2004 (C:\MDI Trainin PubiclEconomies REVISIONS 2004\Manual\ECONOMIC DOC Ver 06Boyer im] DIT) INTERNATIONAL Project Economics & Decision Making The Impact of Exchange Rates We shall now add to our “complicating” factors by considering the impact of exchange rates on our project investment decisions. Our examples and exercises so far have assumed that all of the cash inflows and outflows are in the same currency over the life of our projects. We shall now consider how to take account of different currencies within our discounted cash flow decision models. Revenue received for international sales of oil and gas are most often in USS, but for national supplies they are commonly in the local currency of the country. Equally, the expenditures can be a mix of the currencies of the countries where international service and construction companies are based. Additionally, local suppliers will naturally price in local curreney. So projects often contain a mix of USS, £ Sterling, Euros, Japanese Yen, etc., and local currency. ‘This means that we have a choice of how we handle exchange rates in our calculations as shown below: 1. Allin us $ allows the direct relation of costs to the value of sales allows all projects to be assessed on the same currency basis for comparability 2. All in local currency = used where the company’s strategy or local requirement exist to reinvest ‘earnings in the source country - allows correct local tax calculation 3. All in your company’s home reporting currency e.g. £ for a UK based company - allows final impact of projects to be seen as they affect the company & shareholders ~ allows all projects to be assessed on the same currency basis ‘The third option Home Reporting Currency is one of the most commonly used. The following diagram shows how a mix of exchange rates are converted into a common currency, in this case £ Sterling Project Economics & Decision Making 39 ©MDT International 2004 CC:MDT Trainin Puble\Boonomic REVISIONS 2004WManualECONOMIC DOC Ver 06MDT) ee nea Project Economics & Decision Making /£ X RATE MOD US$ pobdceeaa MOD £ SALES VALUE SALES VALUE | MOD EURO EURO/E X RATE COSTS ——— }_,|(Mop £ costs) MOD LC LCi£ X RATE cCOsTs ———_ MOD £ CASH FLOWS Then deflate & discount Project Economics & Decision Making 4 ©MDT International 2004 (CAD Training Publ Economies REVISIONS 2004\anual CONOMIC.DOC Ver 06000 econ Project Economics & Decision Making O EXAMPLE - EXCHANGE RATES Your company is planning to install a new computer system with a capital cost of €10,000 as a result of new contract the company has been awarded The sales revenue generated by using the new system will be $10,000 p.a, for 5 years. The incremental costs for the contract are estimated at Local Currency (LC)5,000 p.a. estimated to rise by 10% p.a. Your company wants to see the results of the project in £ Sterling and your corporate HQ have forecast exchange rates to be: $1.50/£; €1.60/£; and LCS.00/ The results of the project in £ Sterling MOD are shown below. Sales | Costs i Exch Rate/ Year $MOD $:£ £MOD Currency Amount £ £MOD £MOD 0 ease 10,000 1.60 6,250 - 6,250 1 10,000 1.50 6,667 | Lc 5,000 5.00 1,000 5,667 2 10,000 1.50 6967| LC 5,500 5.00 1,100 5,567 3 10,000 1.50 6,667, LC 6,050 5.00 1,210 5,457 4 10,000 1.50 6,667, LC 6,655 5.00 1,331 5,336 5 10,000 1.50 6,667, LC 7,320 5.00 1,464 5,203 a aa ‘The NPV of the project would then be calculated after deflating using a consistent UK general inflation rate to arrive at REAL £ values, and then discounting at the required company rate as shown in the example in the previous section. SS Project Economics & Decision Making 4 ©MDT International 2004 (CAMDT Training Publicconomic REVISIONS 2004 MamualiBCONOMIC.DOC Ver 06My D]T) ee cea Project Economics & Decision Making The Impact of Taxation Introduction We shall now add further to our “complicating” factors by considering the impact of taxation on our project investment decisions, We shall confine our attention to the consideration of company or corporation tax (CT) and base our explanation on the UK taxation framework. It is outside the scope of this training course to explain and illustrate the tax regimes of more than one country. In this section you will learn that: * UK corporation tax is payable on the taxable profits of a company earned during its financial year * that CT is paid in cash to the government in four quarterly instalments, with little delay between generating profits and paying the corresponding tax * the profits earned by a company in any year are unlikely to equal the cash ‘earned by the company during the year UK Corporation Tax Corporation tax is assessed on the trading profits of a company at a rate of 30%, with adjustments e.g «depreciation, which is substituted by capital allowances © interest payable : © appropriations and transfers to reserves + revenue expenditure incurred more than three years from commencement of trade «© expenditure not *wholly or necessarily" incurred as a result of being. in business, e.g. charitable donations, political contributions CT is chargeable on the taxable profits of a company eared during the normal 12 month period for which it makes up its accounts. The tax is payable in four quarterly instalments, with little delay between the earning of profits and payment of the corresponding tax. Project Economics & Decision Making 2 ©MDT International 2004 (CIMT Traiming\Pub le Economics REVISIONS 2004 ManuallBCONOMICDOC Ver 06000 ue heat Project Economics & Decision Making Legislation has been enacted in the UK to deal with CT aspects which are specific to the petroleum industry, e.g, . Finance Act 1973 introduced the taxation of activities in UK territorial waters as if they were carried on in the UK © Oil Taxation Act 1975 placed a ring fence around offshore oil profits to prevent tax being reduced by relief from elsewhere. . Finance Act 1975 restricted relief for unused trading losses of "Oil Companies” brought forward from 31 December 1972 in excess of £50,000,000 Main treatment of costs: . Seismic Expenditure is 100% deductible as Scientific Research Allowances + Exploration/Appraisal Wells Expenditure is 100% deductible as Scientific Research Allowances * _ Development/Production Wells: * Tangibles- Plant & Machinery 25% Writing Down Allowance Writing Down Allowances In the previous section, we referred to "25% Writing Down Allowances" and to Scientific Research and revenue expenditure being 100% deductible as a trading expense in the year in which they are incurred. So what do we mean by a "Writing Down Allowance” and what is its impact on profit? Under UK CT rules, capital expenditure on items classified as Plant and Machinery (which represent most E&P capital expenditure) is allowed, on the basis of an annual 25% of a reducing balance, to offset a company's CT liability’. The following example illustrates why decisions to capitalise or expense expenditure have a bearing on reported profits and on how much the tax man takes in any given year. } Note: In the UK an exception to this “rule” is for Plant and Machinery assets that have an expected life ‘greater than 25 years, e.g. gas pipelines. These assets only qualify for a 6% Writing Down Allowance. Project Economics & Decision Making B ©MDT International 2004 MID? Training Publ conomics REVISIONS 2004WMemual¥BCONOMIC.DOC Ver 06Project Economics & Decision Making O EXAMPLE - WRITING DOWN ALLOWANCE New Oil Company buys an item of capital equipment in Financial Year 0 for £1,000,000. 25% of this amount (£250,000) can be used to offset the company's CT liability for this year. For Year 1, the allowance is given on the "Written Down Value" of the capital item, ie. the original cost (£1,000,000) less the Year 0 allowance (£250,000). The written down value at the end of Year 1 is therefore £750,000 less 25%, or £562,500. This amount qualifies for the Year 2 Writing Down Allowance at a rate of 25%, viz. £140,625. The table below shows how this would work over a 10 year period. Year Value of 25% Writing Equipment at _ | Down Allowance inning of Year CO) £1,000,000 £250,000 1 £750,000 £187,500 2 £562,500 £140,625 3 £421,875 £105,469 4 £316,406 £79,102 5 £237,305 £59,326 6 £177,979 £44,495 7 £133,484 £33,371 g £100,113 £25,028 [eeea £75,085 £18,771 | The next table how the writing down allowance is applied to reduce New Oil Company's CT bill Year | Taxable 25% Writing Taxable CT @30% Income before Down Income after WDA Allowance WDA 0 | _£10,000,000 £250,000 £9,750,000 £2,925,000 1| _ £15,000,000 £187,500 |__£14,812,500 £4,443, 750 2 £20,000,000 £140,625 |__ £19,859,375 £5,957,813 3 |__ £20,000,000 £105,469 |__£19,894,531 £5,968,359 4 £20,000,000_ £79,102 £19.920,898 £5,976,269 5 |__£15,000,000 £59,326 | £14,940,674 £4,482,202 6 | £10,000,000 £44,495 £9,955,505 £2,986,652 7 £8,000,000 £33,371 £7,966,629 £2,389,989 8 +£6,000,000 £25,028 £5,974,972 £1,792,492 9 £3,000,000 £18,771 £2,981,229 £804,369 Project Economics & Decision Making CCMDT Training Public Zconomics\REVISIONS 2004\ManualECONOMICDOC Ver 06 ©MDT International 2004 4MD] T) eee Project Economics & Decision Making It is interesting to compare the above CT liability in the first five years with what the liability would have been had the expenditure been operating expense: Year Taxable Tax ‘Taxable CT @ 30% Income before | Allowance | Income after £1m expense Allowance | £10,000,000 [~£1,000,000 £9,000,000 £2,700,000 1 £15,000,000 =| £15,000,000 £4,500,000 2 | £20,000,000 = | £20,000,000 $6,000,000 3 | £20,000,000 =| £20,000,000 £6,000,000 4 | £20,000,000 =| £20,000,000 £6,000,000 The sum of the CT liability in the top table after five years is £25,271,191 The sum of the CT liability in the bottom table after five years is £25,200,000. This illustrates that the impact of decisions to capitalise or expense tends to even itself out in the long run while the annual data in the tables show that there is a significant cash flow benefit from writing off (expensing) the expenditure wherever permissible. Impact of Tax on the Cost of Capital Another impact of tax on a company is to reduce its after tax cost of capital. This is illustrated in the following example. O EXAMPLE - IMPACT OF TAX ON COST OF CAPITAL We shall assume that our company is financed as follows: Proportion of Gross Cost After Tax Cost Finance Debt 50% 8.0% 5.6% (gross - 30%) Equity 50% 15.0% 15.0% The weighted average before and after cost of capital can be calculated as follows: Before Tax Cost of Capital _{(50% x 8.0%) + (50% x 15.0%)} = 11.5% After Tax Cost of Capital _{(50% x 5.6%) + (50% x 15.0%)} = 10.3% ES Project Economics & Decision Making 6 ©MDT International 2004 CC:MDT Training|Public\Boonomiet REVISIONS 2004MamualECONOMIC DOC Ver 06000 een Project Economics & Decision Making ‘Now that we have illustrated the impact of tax on the cost of capital, we can take our calculated after tax cost of capital and apply it, as the discount rate, to the cash flow streams, taking account of: * eligible writing down allowances for the project * project profits © the timing of the tax payments O EXAMPLE - IMPACT OF TAX ON DISCOUNTED CASH FLOW ‘New Oil Company is considering investment of £20,000 in a project which will generate the following positive, before tax, cash flows. These will be received in the financial years which immediately follow the year of investment (Year 0). Year 1 £10,000 Year 2 £ 8,000 Year 3 £ 6,000 Year 4 £ 4,000 Year 5 £ 2,500 The company will be entitled to annual CT writing down allowances (WDA) of 25% for capital expenditure on “plant and machinery”, which will be the overwhelming majority of its capital expenditure. CT payments are made under a quarterly payment scheme which results in a negligible effective payment delay. The CT rate is 30%. We will assume that the after tax cost of capital is 10%. Tax Calculation Cash Flow Year Cash WDA Taxable Tax@ Gross ‘Tax NetCash Discount NPV Flow Profit 30% © Amount Payment “~ Flow Factor © -20,000 5,000 5,000 1,500 -20,000 1,500 -18,500 1.000 -18,500 1 10,000 3,750 6,250 1,875 10000-1875 8,125 0.909 7,386 2 8000-2812 5,188 1,556 8000-1556 6444 0.826 5,323 3 6,000 2,110 3,890 1,167 6,000 -1,167 4,833 «0.751 (3,630 4 4000 1,582 2,418 ns 4,000 MS (3,278 0.683 2,237 5 2,500 1,187 1,313 394 2,500 394 2,106 0.621 1,308 Total 41384 —— The project results in an NPV of +£1,384 after tax. Project Economics & Decision Making 46 ©MDT International 2004 CC-IMDI Tratming\PubileEconomics REVISIONS 2004ManualIBCONOMIC.DOC Ver 06000 Bee arene Project Economics & Decision Making The above illustration shows the timing impact of the annual writing down allowance and the fact that tax on the project’s profits is paid essentially within the year in which they are earned. Note: Strictly speaking we should continue showing the favourable impact of remaining writing down allowances until they have been fully utilised. This would take up to year 40, and only then because there is provision in UK tax legislation for bringing forward the balance of the WDA remaining after 40 years! They are, therefore, often ignored in after tax decisions, especially those based on discounting future cash flows. Project Economics & Decision Making a7 ©MDT International 2004 (C:MDT Training Pubic Economes\ REVISIONS 2004\ManualECONOMIC DOC Ver 06iM] DIT) Brea ern te Project Economics & Decision Making Incremental Development Investment A common investment occurrence is the analysis of incremental investments in fields which have already been developed and are producing. The dilemma that this poses is: + Should previous development investment be taken into account when calculating the rate of return? * Does the same rate of return apply to incremental investments? A suggested methodology for dealing with this is to consider only the impact of incremental revenues and costs that result from an investment proposal, i.e. sunk, or historic, costs are ignored. The criteria for acceptance is the same as that for accepting any type of investment proposal, ic. incremental investments do not require to achieve higher rates of return or PI’s than any other type of investment. In practice, E&P companies maintain life of field economic models capable of calculating the post tax economics of a producing field. The incremental cash flows of an additional investment can be added to this mode! to obtain a comparison of the with and without additional investment. Criteria for Decision Making If the incremental investment improves the life of field economic indicators, the project may be accepted If the incremental investment worsens the life of field economic indicators, the project may be rejected. Project Economics & Decision Making B ©MDT International 2004 ‘CAMDI Training Public Economics REVISIONS 2004Manual!€CONOMIC.DOC Ver 06000 Project Economics & Decision Making Other Indicators ‘So far we have concentrated on discounted cash flow techniques to obtain quantified measures to support decision making, This may leave the trainee with the impression that there is nothing else to quantify. But how, if at all, can we reconcile the accountant’s measures and the economist’s? The accountant is concemed with the measurement of profit and the timing of projected profits. Profits are required to make dividend payments to shareholders and to maintain the value of company’s share prices on the stock markets. TS O EXAMPLE - RELATIONSHIP OF ECONOMIC INDICATORS TO ACCOUNTING INDICATORS A satellite field development proposal has the following revenue and expenditure streams: ‘Undiscounted Cash Flows ($000) Year "Revenue Capex Opex Total Cost Tax CashFlow Discount = NPV Factor @ 10% 0 “16,168 “16168 —«1213_—~—~=14,955 1000 -14,955 1 65,162 65,162 «5,797 —_-59,365 0.909 -53,963, 2 56879-15943 12,422 28,365 -7,794 20,720 0.826 17,115 3 67671 -13,754 -16,045-29,799--10,299 27,573 0.751 20,707 4 62719 0 12,717 12,717 -11,109 38,893 0.683 26,564 5 40,345 0 9327-9327 6,387 24,631 0.621 15,296 6 16,207 0 41270 4127-1435 10,645 0.564 6,004 7 9473 o 27m 271 “387 6,375 0.513 3,270 8 7.424 0 1,605 1,605 “S15 5,304 0.467 2,477 Total 260,718 -111,027 -58,954 169,981 30,916 59,821 2,515 ——— The above cash flow stream is equivalent to the following Profit Projection. Note that Capex has become Depreciation in order to match Capex with Sales Revenue period by period (normal accounting convention), Tax is net of relief given against interest payments, the project being assumed to be financed by a loan. In the table above, interest payments do not appear because overall company funding is considered, and then only through the discount rate, which is net of any tax relief. Note also that the total Profit of the project over its life equals the total undiscounted cashflow over the project’s life, less the interest costs ($29,000), plus tax relief against interest costs ($8,700). It is only the timing of the annual profits and cashflows that differ. Project Economics & Decision Making ao ©MDT International 2004 (C:MDT Training Pubic\Economies REVISIONS 2004\ManualSCONOMIC DOC Ver 06Project Economics & Decision Making 000 Reece Profit Projection (S000) Year ‘Revenue Depreciation Opex Interest Total Cost Tax Profit 0 -2,000 =2,000 1,813 -187 iq 6,000 6000-7597 1,597 2 36879 = 21,221 12,422, -9,000 42,643 -5094 94142 3 67671 29.818 16,045 6,000 51.863. 8.499 73309 4 62,719 27,709 12,717 4.000 44.426. 94.9098 384 5 40345-18181 -9,327 2,000 29,508 5,787 5.050 6 16,207 6902 4,127 0 -11,029-1435 3,743 7 9473 4034 -2.711 0 6,745 “3872341 8 7428 3,162 -1,605 0 4,767 “SIS 2,142 Total 260,718 -111,027-58,954 -29,000--198,981 22,216 39,521 ‘The next step is to measure the impact on the company’s projected Balance Sheet. Balance Sheet Projection (Smm) Year st Oa sees e eras Fixed Assets Intangible SO S050 S050) 50h 50 0 a0 90 Tangible 1030 1046 1111 11271120 1090-1062 104410371033 Depree’n ® © @ @ GB @ 4 © & 1080 109611611156 11401112 1094 108710831080 Current Assets Stocks Sess ig ie ig ee Debtors B88 183838 BB BB. Cash ape gee g egg ace aca g rere ga eaegiccig 160 160 160 160 160 160 160160160160 Current Liabilities Creditors - short term (80) (82) (88) (85) (84) (83) (82) (80) (80) (80) Net Current Assets 80 78 «72750 %H—(iwT HOBO Total Assets less Current Liabilities 1160-174 12331231“ 1216-89 I7_sGT 16316 Creditors longterm (400) 14) (471) (460) (438) 403) G81) G72) 366) G61) Provisions 200) 200) (200) (200) 200) (200) (200) (200) (200) 200) Net Assets 560 560 562, S7l_«S78_ 586 S155 597599 Capital & Reserves Share Capital 200 200 200 © 200 © 200-200» 200 200 200200 Retained Profit 360 360362 STL B3KG_ L395 397399 560 560 562 S71 S7R_ 586 S595 597509 Debv/Equity O71 074 084 081 0.76 069 0.65 0.63061 0.60 Project Economics & Decision Making 50 ©MDT International 2004 (CMI Trainng\Pubiteconomies\REVISIONS 2004\MamvallBCONOMICDOC Ver 05:im[D]T) ea ie Project Economics & Decision Making The Balance Sheet shows the impact of the project on the company’s Debt/Equity Ratio. The impact must be measured against any objective that the company has to maintain this ratio within a certain range consistent with its business strategy. The projection shows that the company is capable of returning to its starting Debt/Equity Ratio within 5 years (assuming no payment of dividend!) It also shows that the company would be capable of reducing its long term borrowing (again assuming no payment of dividend!) This allows us to see the impact of the project on two key financial performance areas: . dividend performance © debt management It should be noted that the above projection is a simplified impact of the project on the company’s overall position. The projection would also include the financial impact of all the activities that the company is already committed to plus, possibly, the impact of other activities which the company is considering whether to undertake. el Project Economics & Decision Making SI ©MDT International 2004 CC-MDT Training\Publc Economics REVISIONS 2004WManual ECONOMIC DOC Ver 05MD] T) une Project Economics & Decision Making Dealing With Uncertainty and Risk All our illustrations to date have dealt with the “perfect world” devoid of uncertainty and commercial risk. The world, clearly, is not that perfect, How, then, might we try to take account of associated uncertainties and risks when making our project proposals? This section will examine the following techniques that attempt to deal with uncertainty and to quantify project risks: © Payback period © Maximum Exposure © Sensitivity Analysis © Probability Theory © Decision Trees © Expected Monetary Value (EMV) Payback Period This is a relatively simple assessment of the risk associated with a project. The longer the payback period, the higher the risk in that all or part of the initial investment is at risk for a longer period of time. The weakness of the method is that it is subjective in that it only considers time and not the magnitude of the investment. ‘As we saw earlier in the course, the payback period may be calculated on an tundiscounted basis (see p13) or the project cash flow may first be discounted (see p24), thus taking account of the time value of money. Maximum Exposure Maximum exposure is the maximum cumulative cash outflow from a project. The cumulative cash flow is initially negative and becomes a larger and larger negative number until the first year in which there is a positive annual cash flow. From this point the negative cumulative cash flow reduces in size and the cumulative cash flow eventually becomes positive (at the end of the undiscounted payback period), Earlier in the course, we looked at the concept of NPV/Max Exposure (see p30) and illustrated the concept with the following example, to which the complicating factor of tax has now been added. Project Economics & Decision Making 52 ©MDT International 2004 C:MDT Training\Public\Economics\REVISIONS 2004\ManualK{CONOMIC.DOC Ver 06iM] D]T) ne reer n Project Economics & Decision Making O EXAMPLE - MAXIMUM EXPOSURE A satellite field development proposal has the following revenue and expenditure streams Undiscounted Cash Flows (S000) Year Revenue Capex Opex Total Cost Tax Cash Flow Cumulative Cash Flow 0 “16,168 0 “16,168 =16,168 1 65,162 ° 65,162 81,330 2 56,879 “12422-28365 6,042 2,472 58,858 3 67671 -16,045 29,799 8,985 28,887 29.971 4 62.719 12,17 12,717 -10,123 39,879 9,908 5 40,345 “9327 9,327 -5.647 25,371 35,279 6 16207 4127-4127 -880 11,200 46,479 7 9473 271-2711 29 6.791 53,270 Sata 7an -1605 ——-1,605 -202 5,617 58,887 Total 260,718 111,027 -58,954 169,981 -31,850 58,887 Maximum Exposure = $81,330,000 Payback period (undiscounted) = 3 + ($29,971/$39,879) = 3.75 years ‘The above project’s Maximum Exposure is $81,330,000 (the sum of Year 0 + Year 1 negative cash flows). This indicates that, in the worst scenario, if the project is totally unsuccessful, the company could stand to lose $81,330,000. Stark figures like this often sharpen management’s mind into considering the risks they are taking with the company’s money! It is obviously simple to use this technique to compare the relative Maximum Exposures of a range of alternative projects. This would be appropriate to small project portfolios or conditions of strict cashflow constraint, but if neither applies ranking by NPV/Maximum Exposure should be considered (see p30). Small values rather than large ones will now indicate relatively high risk. The Maximum Exposure technique can be further refined by combining the Maximum Exposure of the project with the length of the Payback Period. The above risk could be expressed as an exposure of up to $81,330,000 over 3.75 years. The undiscounted payback period would normally be used, as Maximum Exposure is not discounted. Project Economics & Decision Making 53 ©MDT International 2004 (C:AMDI Training Public Economics REVISIONS 200¢\Manuall ECONOMIC DOC Ver 06000 a cee Project Economics & Decision Making Sensitivity Analysis Sensitivity analysis consists of changing the value of one or more of the variables that will influence the outcome of an investment decision. The percentage or absolute value of the different outcomes can be measured versus the changes in the variable(s). This gives a “feel” for how sensitive the project may be to changes in variables such as sales Price, sales volume, costs, inflation, tax rates, etc. We can combine sensitivity analysis with probability theory and the technique of decision trees to try to quantify the value of alternative sensitivities. Spider/Star Diagrams The sensitivity of different variables can be shown graphically by drawing a Spider Diagram - see Figure 1. The horizontal axis measures the percentage deviation of each variable from the base case. The vertical axis shows the NPV @ 10%. Only one variable is altered at a time, holding other all other variables constant. The steeper the line, the more sensitive the outcome is to a change in that variable. NPV @ 10% ($mm) 8 6 4 2 o A 4 4 3 Project Economics & Decision Making 7 ©MDT International 2004 AMDT Training PublcWEconomies REVISIONS 200#tMamualECONOMIC.DOC Yer 06O0O oer nt Project Economics & Decision Making Tornado Diagram Big Oil Field Prospect NPV @ 10% (sm Figure 2 Tord Diagram Figure 2 shows a Tomado Diagram. It plots the same data as Figure 3 - Spider Diagram. The wider the horizontal line for each variable at equal extremes of percentage variance, the more sensitive is the outcome to that variable. Project Economics & Decision Making 55 ©MDT International 2004 ‘CAMDT Traning\PublicconomicREVISIONS 2004\Marual\BCONOMIC DOC Ver 06im] Dy 1) uote Project Economics & Decision Making Probability Theory Many of our illustrations have focused on the factors that determine decisions to explore for and/or exploit petroleum reserves. Here we shall add to the decision model the element of risk that is attached. This risk can be expressed as the probability of an outcome, e.g, + probability of commercial reserves within a licence block + probability of recoverable reserves being within a certain order of magnitude Our decision model might now look like this: DECISION = PETROLEUM POTENTIAL + ECONOMICS + RISK We have stated before that the upstream petroleum industry is typified by the high levels of investment required and the high risks involved, ie. no certainty that commercially exploitable reserves will be found as a result of high investment in exploration and development, Probability theory attempts to remove and quantify the risks involved by expressing outcomes in terms of percentage likelihoods. For example, data gathered about drilling in a certain territory might indicate that: + structural conditions (e.g. faulting, type of trap, subsurface control) were correct 60% of the time * good reservoirs (e.g. rock properties, depositional conditions) were present 40% of the time + the proper environment (e.g. shows, paleohistory, proximity of source beds) was present 75% of the time In this simplified example, the probability of the correct conditions for finding petroleum can be expressed as: 0.6 x 0.4 x 0.75 = 0.18 = 18% It is normal to run sensitivities on various parameters and assumptions within an investment decision model by varying these by, say, factors of 5-10% to assess the impact on overall economics. Probabilities can be attached to the various sensitivities, and combinations of them, to assist in decision making Project Economics & Decision Making 56 ©MDT International 2004 (CAMDT Training\Public\Fconomics REVISIONS 2004\Marual'BCONOMIC DOC Ver 06iM[ DIT) tue cee Project Economics & Decision Making Decision Trees and Expected Monetary Value Constructing a decision tree is a technique that permits the structuring of a problem with uncertainties. The technique involves assigning probabilities of outcome to uncertain events and applying the probability of the outcome to the NPV of the ‘outcomes to compute an Expected Monetary Value (EMV). The EMV is often referred to as the risk adjusted NPV. The process of developing a decision tree involves the following step-by-step process: Step 1 - Identify the decision alternatives, Step 2 - Identify the possible outcomes from each alternative Step 3 - Calculate the NPV of each alternative Step 4 - Identify the probability of each alternative Step 5 - Calculate the EMV of each alternative by multiplying the NPV by the probability The decision is influenced by the option which has the highest aggregate EMV. The example on page 58 illustrates the methodology. Project Economics & Decision Making 57 MDT International 2004 C:MDT Trainin\Publi\Economics REVISIONS 2004 Wana ECONOMIC.DOC Ver 06000 oor n Project Economics & Decision Making EXAMPLE - DECISION TREE A company is trying to decide between two investment. opportunities, Project A and Project B. They have evaluated the possible outcomes of the two alternatives and calculated the NPV of each option. The decision tree is summarised below. Each option has been assigned a probability. The EMV has been calculated by multiplying the NPV by the probability of each option. Project B has the marginally higher EMV and is preferred. The symbol H is used to indicate a decision point. The symbol O is used to indicate the uncertain outcomes. NEV EMV High 4,000 200 3,000 2,790 2,000 40 3.030 8,500 340 3,500 3,045 (1,000) (80) (3,000) (30) 3.278 Project Economics & Decision Mating 38 ©MDT International 2004 (C:MDI Training Pubic EconomicsIREVISIONS 2004\ManuaECONOMIC DOC Ver 06iM{D]T) INTERNATIONAL Project Economics & Decision Making Packaging the Proposal We now come to the stage of the project where you have to convince someone, whether in your own company, or possibly your co-venturers, that the project is a g00d idea. We have explored in some detail how you might go about justifying the project on economic or commercial grounds. So, how might you “package” your proposal to obtain the budget funds that might be required? As the “Project Manager”, you now have to change hats and become the “Project Salesman” - you have to “sell” the idea to management. This will call upon you to apply your best selling skills. Put yourself in the “‘buyer’s” shoes and ask yourself what you would be looking for if you had to sign the chequebook. The first exercise, The Ingredients of the “Perfect” Project Proposal, is designed to highlight what your project proposal might contain and how it should be structured. Fundamental Management Questions The project proposal would provide answers to the fundamental questions that will go through the minds of any management “buyer”. Simple questions to ask when someone is putting a proposal to you are (not necessarily in this order): © Who? What? ° Where © When? * Why? * How? Let us now see how we can adapt this questioning approach to put the questions into a logical order that will help us structure our proposal and “sell” the proposal to management. Structuring Your Proposal A fundamental rule in selling anything is BE POSITIVE. Our suggested approach is to stress the benefits of a project proposal. Ifthe benefits are not clear to you, they will not be clear to anyone else. We do not buy goods, services or commodities; we buy the benefits that we derive from our purchases of tangibles or intangibles. We make those purchasing decisions because we have become convinced that the benefits we will enjoy from our purchase will exceed the cost of the purchase. Always start with Project Economics & Decision Making 39 ©MDT international 2004 MOT Train PubleSooomles REVISIONS 2004tMamaECONOMIC DOC Vor 06000 NTERNATIONAL Project Economics & Decision Making positive statements - the benefits. See the exercise, The Ingredients of the “Perfect” Project Proposal, for examples of positive and negative statements So, what’s the first thing the buyer wants to know? We would suggest the benefits. You must, therefore, first answer the question “why?”. Next we must convince the buyer that we have a way of delivering the promised benefits - we must answer the questions “what?” and “how?”. Now that you have the buyer interested, you must not keep your customer waiting, so answer the question “when?” the benefits will be available. Next advise your customer “who?” will deliver the benefits. Finally, we suggest you tell the buyer “how much?”. Yes, we will leave the price till the end or near the end. Remember, our approach is to stress the positive. By stressing all the positives, the cumulative impact in an effective proposal will be that the positives will outweigh any negative impact of price. Sound familiar? Remember the last time you bought a car? Let us now put a bit more structure around the above framework by examining each of the above questions in more detail and attaching some more meaningful descriptions to the questions. Our suggested project proposal structure is as follows Project Objectives - answers the question “why?” Project Scope - answers the questions “what?” and “how?” Project Schedule - answers the question “when?” Project Organisation - answers the question “who?” Project Economics - answers the question “how much?” We also suggest an optional section on Project Risk Assessment. Project Objectives The exercise, The Ingredients of the “Perfect” Project Proposal, illustrated different ways in which this section could be started. The golden rule is - start with a positive statement. State the positive outcome first, not what you are going to do or how you are going to achieve it. In other words, answer the question “why?” The objective can be stated as an overall business objective. To emphasise the positive, summarise the project benefits, e.g. “The project will result in a NPV of.....” or “The project will generate an Internal Rate of Retum of ....” or “The project will result in an increase in Net Income of ....” or “The project will result in annual operating costs savings of...” Project Economics & Decision Making 60 ©MDT International 2004 C:MDT Training Public Economics REVISIONS 2004tMamual¥ECONOMIC.DOC Yer 06000 eee cee Project Economics & Decision Making Consider too the “soft” benefits. “The project will increase our knowledge of that part of the reservoir.” or “The project will reduce staff turnover.” or “The project will improve customer service.” Project Scope This section will explain what the project consists of in more detail and the methods that will be employed to carry out the activities. Project Schedule This section will summarise the major tasks and activities involved in the project and when they are planned to start and finish. This can be summarised in a project Gantt chart ‘A separate project proposal appendix is often appropriate to illustrate the project tasks and activities in detail. Project Organisation This section will describe how you propose to resource the project with people, their responsibilities, their deliverables, their level of commitment to the project (full or part time) and the lines of authority and communication. A project management chart should be drawn showing who has overall responsibility for the outcomes of the project and to whom the person is responsible. Project Economics This section will demonstrate the overall commercial viability of the project according to economic and/or financial criteria. These criteria have been explained and illustrated in the previous section on Economics and Decisions. A separate project proposal appendix is often appropriate to illustrate some of the more detailed calculations and cash flows associated with the proposed project. Project Risk Assessment This is a discretionary heading and not applicable for all projects. A thorough evaluation of the inherent risks attached to a project demonstrates to management that the downside has been considered as well as the upside. More constructively, the risk assessment section should address measures that will be taken during the project to mitigate or eliminate identified risks of failure. Project Economics & Decision Making 6 ©MDT International 2004 C:MDI Training Pubic conomicsIREVISIONS 2004\ManuaECONOMIC DOC Ver 05Project Economics & Decision Making Post Project Appraisal ‘Much management attention normally focuses on the project decision, the data and the assumptions which are made and the results that arise. Post project appraisal is the technique of measuring and comparing the actual results arising from a project decision and comparing those with the planned results. The technique is not universally applied throughout industries which use investment appraisal techniques on which to base their project decisions, nor is it universally applied within the petroleum industry. It is included in this training programme to give participants an appreciation of a control mechanism which companies may adopt to ensure they achieve the benefits which were originally planned and, if not, what lessons can be learned and applied elsewhere in the organisation on future occasions, Many organisations spend a considerable part of their resource to monitor and control day to day expenditures. The focus tends to be on actual cost vs planned cost, ignoring the timing of the cash flow streams. Post project appraisal is results oriented and seeks to establish whether the commercial results were actually obtained from the original project that was justified, i.e. was the original decision a sound decision and does any corrective action need to be taken in order to obtain the full benefits. The elements of post project appraisal consist of: + a review of the basis of the original project decision and of the original assumptions + measurement of additional revenue streams or production volumes obtained as, a result of the project . ‘measurement of the actual timing of the additional revenue arising from the ‘investment © quantification of the value of the additional revenue arising from the project quantification of the actual project cost and the actual timing of the investment stream © comparison of actual results with planned results and identification of reasons for differences, e.g. timing, price, cost, production, risk There are a number of practical difficulties when applying the technique in practice, eg . if no incremental production accrued, can it be determined that the project, e.g. enhanced recovery, was a “failure" or might the absence of incremental production be attributable to other operational circumstances? Project Economics & Decision Making 0 ©MDT International 2004 CC-IMDI Training\PubieBeonomies\ REVISIONS 2004 Manual ECONOMIC.DOC Ver 06,O00 Ria eee Project Economics & Decision Making + how do we measure the benefits from projects which claim to recover additional reserves over the life of the field? The technique is not universally accepted in organisations and gives rise to the following questions. The suggested answers should not be taken as definitive and rigid but interpreted as guidelines which some organisations have adopted. + Why should the technique be applied at all? + to give confidence that the information and assumptions on which decisions are based are sound + to allow corrective action to be taken where interim results suggest that ‘outcomes are not being achieved + ensures accountability of actions and improves quality of decisions + allows actual results from one decision to be factored into future similar evaluations within an organisation © What investments will be subject to appraisal? + those over a certain planned investment value + those with a certain forecast NPV + those which are subject to high risk . those which have a high repeat factor within an organisation + When should the audit be conducted? + at a point during the investment cycle when there is an opportunity to “get out” with minimal loss + at a point during the development when there is still an opportunity to take corrective action + at some point after the end of the development programme when all the results from the investment should be capable of measurement and the results achieved + Who should conduct the appraisal? + the person(s) responsible for the original investment proposal Project Economics & Decision Making 6 ©MDT International 2004 CCAMDT Training\Public\conomis\REVISIONS 2004 Manual ECONOMIC.DOC Ver 06,Project Economics & Decision Making : technical or operations personnel who were not directly involved in the al investment proposal but who had a responsibility for implementing the proposal + finance or economics professionals who are independent of the original investment decision Opponents of the technique argue: post investment audits look for "scapegoats" when results have not gone according to plan the persons conducting the audit have failed to appreciate the full technological impact of the investment results from audits add no value to future decision processes investment decisions are unlikely to be reversed or suspended due to the audit alone - other factors will already have come to light which will influence such decisions Project Economics & Decision Making o ©MDT International 2004 MDI Trining Publi conomice REVISIONS 2004 Manual!8CONOMIC DOC Ver 06Exercises Contents Contents. OoooooooOoOooooooOoOoo0o0o0o0o00000000000o0 Botehe 000 fet EXERCISE - ACCOUNTING RATE OF RETURN ANSWER - ACCOUNTING RATE OF RETURN. EXERCISE - PAYBACK PERIODS COMPARED. ANSWER - PAYBACK PERIODS COMPARED EXERCISE - NET PRESENT VALUE ANSWER - NET PRESENT VALUE..... EXERCISE - DISCOUNTED PAYBACK PERIOD. ANSWER - DISCOUNTED PAYBACK PERIOD. EXERCISE - INTERNAL RATE OF RETURN. ANSWER - INTERNAL RATE OF RETURN... EXERCISE - PROFITABILITY INDEX. ANSWER - PROFITABILITY INDEX. EXERCISE - CAPITAL RATIONING. ANSWER - CAPITAL RATIONING... - EXERCISE - RISING PRICES, COSTS AND INFLATION (1) 21 ANSWER - RISING PRICES, COSTS AND INFLATION (1)... au 22 EXERCISE - RISING PRICES, COSTS AND INFLATION (2) ANSWER - RISING PRICES, COSTS AND INFLATION (2) . EXERCISE - IMPACT OF TAX ON DISCOUNTED CASH FLOW ANSWER - IMPACT OF TAX ON DISCOUNTED CASH FLOW .. EXERCISE - PROBABILITY OF OUTCOME AND EMV... ANSWER - PROBABILITY OF OUTCOME AND EMV.. CASE STUDY PROBLEM - INVESTMENT vs MAINTENANCE. 32 CASE STUDY ANSWER - INVESTMENT vs MAINTENANCE. CASE STUDY PROBLEM - DEVELOPMENT WELLS. CASE STUDY ANSWER - DEVELOPMENT WELLS........... CASE STUDY PROBLEM - INFORMATION GATHERING. CASE STUDY ANSWER - INFORMATION GATHERING. CASE STUDY PROBLEM - PLATFORM REPLACEMENT. CASE STUDY ANSWER - PLATFORM REPLACEMENT.. CASE STUDY PROBLEM - FIELD DEVELOPMENT. CASE STUDY ANSWER - FIELD DEVELOPMENT. eects CASE STUDY PROBLEM - DEALING WITH UNCERTAINTY... 56 CASE STUDY ANSWER - DEALING WITH UNCERTAINTY...... 59 Project Economics & Decision Making i ©MDT International 1995-2004 C:\MDT Training Public\Sconomics REVISIONS 2004MANUALMEXERCISES doe Ver 06Exercises O EXERCISE - ACCOUNTING RATE OF RETURN ‘New Oil Company is considering drilling a development well to one of two different target locations, X or Y. Each well has a profit (income less cost) as profiled in the following table: Year WellX $ 0 -4,000,000 1 +1,800,000 2 +1,200,000 3 ++1,000,000 4 +700,000 5 +500,000 6 +-400,000 i +200,000 8 +100,000 9 +50,000 10 +50,000 Total Profit _+2,000,000 Average profit a Average investment cage Rate of Return 17). Required Use the ARR method as the decision criterion to establish which of the two wells (if any) should be drilled. ‘The negative profit in Year 0 is equivalent to the initial investment, with its sign reversed. Exclude Year 0 when calculating the number of years. “Year 0” is often used to represent a short period of high expenditure immediately prior to the start of project benefits at the beginning of Year 1 el Well Y $ -3,000,000 +1,400,000 +1,200,000 +900,000 +600,000 +300,000 +100,000 +50,000 +50,000 +1,600,000 pe us 337, Project Economics & Decision Making ©MDT International 1995-2004 CDT Traiing\Pubiiconomics REVISIONS 2004 MANUALVEXERCISES doc Ver 06imp] T) Big ean re Exercises O ANSWER - ACCOUNTING RATE OF RETURN Year Well X Well Y $ $ 0 -43000,000 3,000,000 1 +1,800,000 _+1,400,000 2 41,200,000 +1,200,000 3 +1,000,000 _+900,000 4 +700,000 ++600,000 5 +500,000 —-+300,000 6 +400,000 -+100,000 7 +200,000 450,000 8 +100,000 ++50,000 9 +50,000 : 10 +50,000 : Total Profit +2,000,000—_#1,600,000 Average profit $200,000 $200,000 Average investment $2,000,000 $1,500,000 Rate of Return 10% pa 13.3% pa The above calculation of ARR points to well Y being the better investment. Project Economics & Decision Making 2 MDT International 1995-2004 C:\MDT Traming\Publiconomics\REVISIONS 2004 MANUAL EXERCISES doc Ver 06mM] DTT) ean Exercises O EXERCISE - PAYBACK PERIODS COMPARED New Oil Company is faced with the choice of drilling development well A or B on its Clam Field. Its criterion for investment decisions is that they must achieve payback in three years. Cash flows for each alternative are shown below. Well A ‘Well B ‘Annual ‘Annual Year____Cash Flow Cash Flow $ $ 0 -2,000,000 -2,000,000 1 +500,000 +1,000,000 2 +500,000 +700,000 3 +500,000 +400,000, 4 +500,000. +100,000 5 +500,000 0 6 +500,000 0 Required: Which well(s) will be drilled according to the company's investment criterion? ‘What is the strength and weakness of this method? Project Economics & Decision Making 3 ©MDT International 1995-2004 C:UDT Traning\PubliciBconomic\ REVISIONS 2004.MANUAL EXERCISES doc Ver 06000 isan Exercises O ANSWER - PAYBACK PERIODS COMPARED ‘New Oil Company is faced with the choice of drilling development well A or B on its Clam Field. It criterion for investment decisions is that they must achieve payback in three years. Cash flows for each alternative are shown below. Which well(s) will be drilled according to the company's investment criteria? Well A Well B ‘Annual Cumulative ‘Annual Cumulative Year____Cash Flow Cash Flow Cash Flow Cash Flow 3 $ $s $ 0 -2,000,000 2,000,000 -2,000,000 -2,000,000 1 +500,000 -1,500,000 ——_+1,000,000 1,000,000 2 +500,000 -1,000,000 +700,000 “300,000 3 +500,000 ~500,000 +400,000 +100,000 4 +500,000 0 +100,000 +200,000 5 +500,000 +500,000 0 +200,000 6 +500,000___ +1, 000,000 0 +200,000 Based on the payback period criteria alone, the company would drill Well B as it achieves a payback within the three year period. Well A does not achieve this but it does generate total cash flows in excess of Well B. el Project Economics & Decision Making 4 ©MDT International 1995-2004 C:MDT Tranin\Public\Economics REVISIONS 2004\MANUALMEXERCISES doc Ver 06000 fia eegen ee Exercises EXERCISE - NET PRESENT VALUE New Oil Company is debating whether to install a new computer system. The cost of new equipment has been estimated at $100,000. The annual savings that will result are estimated to be $25,000 p.a. for 5 years. It is forecast that the system will become obsolete and will be replaced at the end of the fifth year. The company's cost of capital is 20%. Required: Does the above proposition appear to be economic on a NPV basis? io lee rg — rH Brs 25 — 1935 oe pote eee ee O40 oa oH 2600S Project Economics & Decision Making 5 ©MDT International 1995-2004 CAMDT Tramg\Pubic Economies REVISIONS 200MANUALLEXERCISES doe Ver 06Exercises O ANSWER - NET PRESENT VALUE The proposition appears to be uneconomic on a NPV basis. The tabulation below shows that the NPV of the project is -825,250. ‘CASH FLOW Year Discount Factor Undiscounted Discounted 20% $ $ 0 1.000 =100,000 =100,000 1 0.833, 25,000 20,825 2 0.694 25,000 17,350 3 0.579 25,000 14,475 4 0.482 25,000 12,050 5 0.402 25,000 10,050 Total 25,000 -25,250 Project Economics & Decision Making 6 ©MDT International 1995-2004 C:WDT Trang Puble\BzonomiesREVSIONS 2004MANUALIEXERCISES doc Ver 06000 Tucan Exercises O EXERCISE - DISCOUNTED PAYBACK PERIOD New Oil Company is faced with a choice between two projects, A and B. Cash flows for the projects are shown in the table below. The company’s cost of capital is 15% and the company requires projects to pay back within four years. Which project (if any) are you going to recommend? You might find it helpful to structure your solution using the blank columns in the table below. PROJECT A (8) PROJECT BS) Discount Cumulative Cumulative Factor Undiscounted Discounted Discounted Undiscounted Discounted Discounted Year _@15% __CashFlow Cash Flow Cash Flow_ __Cash Flow Cash Flow _Cash Flow 1.000 -6,000,000 -5,000,000 - Ss 0.870 3,000,000 2,500,000 20S j- TrerH 0.756 2,500,000 1,800,000} 34e8|- Hr 4o4e 0.658 2,000,000 120,000 2-2&.4e)- 0.6 246 0572 1,200,000 300,000 24S 26 \- O- 217 2488 \eo 03S wvobeusna 0.497 ‘600,000 _ 500,000 one 0.432 300,000 200,000 © 2 © os ee ieee 0376 100,000 100,000 oe 3 78+ 0.327 -3,000,000. -200,000 — @ 0 6 $4/ + O72! t a 4 wh v2 2942) Project Economics & Decision Making 7 ©MDT International 1995-2004 C'MDT Training Public Economics REVISIONS 2004.MANUAL\EXERCISES do Ver 06Exercises CO ANSWER - DISCOUNTED PAYBACK PERIOD The table below shows the calculation of each project’s discounted payback period. Project A pays back within the required four year period whereas Project B pays back within five years. On this basis alone Project A is preferred to Project B. However, comparing the value generated by both projects over their entire life, we see that Project A generates an NPV0. This suggests that Project B is superior to Project A over its entire life even though it takes longer to achieve payback. This illustrates one weakness of the payback method criterion, viz. you may end up accepting projects that destroy investor wealth in the long run and reject projects that are capable of increasing investor wealth. PROJECT AS) PROJECT BS) Discount ‘Cumulative ‘Cumulative Factor Undiscounted Discounted Discounted —Undiscounted Discounted Discounted Year_@15% Cash Flow __Cash Flow _Cash Flow __Cash Flow __Cash Flow _ Cash Flow 0 1.000 6,000,000 -6,000,000 -6,000,000 3,000,000 -5,000,000 _ -5,000,000 1 0.870 3,000,000 2,610,000 -3,390,000 2,500,000 2,175,000 -2,825,000 2 0.756 2,500,000 1,890,000 -1,500,000 1,800,000 1,360,800 1,464,200 3 0.658 2,000,000 1,316,000 __-184,000 1,200,000 789,600 -674,600 4 0572 1,200,000 686,400, 502,400 800,000 457,600 -217,000 3 0497 ‘600,000 298,200 800,600 500,000 248,500 [1800 6 0432 300,000 129,600 930,200 200,000 86,400-—_‘117,900 7 0376 100,000 37,600 967,800 100,000 37,600 155,500 8 — 0327___-3,000,000__-981,000_-13,200 -200,000_-65,400__ 90,100 Total 700,000 -13,200 1,900,000 90,100 Project Economics & Decision Making 8 ©MDT International 1995-2004 C:\MDI Trainin’ Pubic conomies1REVISIONS 2004\MANUAL EXERCISES doc Ver 06OOO eas eeanh Exercises O EXERCISE - INTERNAL RATE OF RETURN New Oil Company is considering a project which will require an initial investment of $13.5, million. The project is expected to generate the following positive cash flows: Year 1 $2,000,000 Year 2 $4,000,000 Year 3 $6,000,000 Year 4 $5,000,000 Year 5 $3,000,000 ‘The company is looking for an IRR of at least 15%. Required: Calculate the IRR of the above project and decide whether it is viable. You may wish to use some or all of the discount factors in the following table: PRESENT VALUE OF 1 Discount Rate Year «10% ~=—«s11% = 12% 13% «= 14% 15% © 16% © 17% ~—*18% 19% © 20% 0 7.000 1.000 1.000 1,000 1,000 1,000 1.000 1.000 1.000 1.000 1.000 1 0.909 0.901 0.893 0.885 0.877 0870 0.862 0.855 0.847 0.840 0.833 2 0.826 0.812 0.797 0.783 0.769 0.756 (0.743 0.731 (0.718 0.706 0.694 3 0.751 0.731 0.712 0693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.683 0.659 0.636 0.613 0,592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.621 0.593 0.567 0.543 0519 0497 0.476 0456 0.437 0.419 0.402 ee You may also find the template overleaf helpful to set out your calculations. Project Economics & Decision Making 9 ©MDT International 1995-2004 CDT Tralnng\PublicZconomics\REVISIONS 2004\MANUAL\EXERCISES de Ver 0671S Exercises ‘Cash Flows SS ar Year Undiseounted | 0% | yy | i =F 7) cag fie! ' - 1 BeR) C781) 2 4 ep 276) 3 t Set] wos’ | s [yas] ja9e) 5 7 6) 1 a Vs eon ~ 157 Project Economics & Decision Making 10 ©MDT International 1995-2004 C:Y4DT Tramin\Publc\Economics\REVISIONS 2004IMANUALEXERCISES doc Ver 06000 Ree et Exercises O ANSWER - INTERNAL RATE OF RETURN Cash Flows Discount Rates Year Undiscounted 12% 13% 14% 15% 0 -13,500 -13,500 -13,500 -13,500 -13,500 1 2,000 1,786 1,770 1,754 1,740 2 4,000 3,188 3,132 3,076 3,024 3 6,000 4272 4,158 4,050 3,948 4 5,000 3,180 3,065 2,960 2,860 5 3,000 1,701 1,629 1,557 1,491 627 254 = 103 -437 —_——— Interpolating between the above results, the NPV is 0 at 13% + {__254 _ x (14% - 13%)} = 13.7% 254 + 103 The IRR of this project is 13.7% which is less than the required return of 15%. The project should be rejected Cee Project Economics & Decision Making i ©MDT International 1995-2004 C:\MDI Trainin Pubic\EconomiesIREVISIONS 2004 MANUAL EXERCISES doe Ver 06