29/02/2016

Koya University
Faculty of Engineering
Department of Petroleum Engineering
Third Stage

Petroleum Economics
Measures of Profitability and Performance
of Projects
Farhad Abdulrahman
Assistant Lecturer

Economical Popular Criteria

Below are criterias might have alternate names, but these
are the common ones in petroleum economics:

Three which ignore time-value of money:

1. Net Profit
2. Payout (PO)
3. Return on Investment (undiscounted profit-to-investment
ratio)
Others which recognize time-value of money:
1. Net present value profit
2. Internal rate of return (IRR)
3. Discounted Return on Investment (DROI)
4. Appreciation of equity rate of return

2/29/2016 Petroleum Economic 2

© Farhad Khoshnaw 1
 29/02/2016

Payout (PO)
• The length of time which elapses until the account
balance is exactly zero is called payout time.
• Strengths:
– Simple
– Measures an impact on liquidity
• Weaknesses:
1. Payout considers cashflows only up to the point of
payback.
2. Especially troublesome with large abandonment
costs
3. Project profits cannot be weighted: (n x average ≠
total)

2/29/2016 Petroleum Economic 3

Return on Investment (ROI)

• Reflects total profitability!

• Sometimes called: (undiscounted) profit-to-investment ratio
• Strengths:
– Recognizes a profit in relation to the size of investment
– Simple
• Weaknesses:
– Accounting inconsistencies / contradictions
– Continuing investment is not represented properly
– Project ROI cannot be weighted: (n x average ROI ≠ total ROI)

2/29/2016 Petroleum Economic 4

© Farhad Khoshnaw 2
 29/02/2016

Net Present Value

• Money received sooner is more worth than money
received later!
• The money can be reinvest in the meantime!
(Opportunity cost of capital)
• The present value can be found by:
𝑃𝑉 = 𝐹𝑉 (1 + 𝑖)−𝑡
Where:
PV: Present Value of future cashflows
FV: Future Value
i: Interest or discount rate
t: Time in years
(1 + 𝑖)−𝑡 :Discount factor

2/29/2016 Petroleum Economic 5

Example 1.0
Consider the project (Name P in Table 1.0) with greatly
differing after tax cash flow patterns where each project
requires only one investment to be made at time zero.
Using the following information:
A. Project life span is 10 years
B. Profit indicators like
i. payout period
ii. discounted cash flow rate of return
iii. net present value (NPV) at 5%, 10% and 15%
Calculate:
1. POP, DCFROR & NPV
2. The future value of project at 10 % discount rate for ten years
2/29/2016 Petroleum Economic 6

© Farhad Khoshnaw 3
 29/02/2016

Table 1.0: CCF Project P

Years P
0 -1000
1 500
2 400
3 300
4 200
5 100
6 50
7 40
8 30
9 20
10 10

2/29/2016 Petroleum Economic 7

Payout Period Calculation

CC𝐹n
Payout Period = n + −−−− −𝐸𝑞(1)
FCn+1
Where:
n : The year before the collective payback goes above the
investment money.
CCFn : The Absolute Collective Payback before the year
where pay back over investment money
FCn+1 : Free Cash Flow on the Year where it went above
investment money

2/29/2016 Petroleum Economic 8

© Farhad Khoshnaw 4
 29/02/2016

Solution of Example 1.0

For this project, a table Years P CCF

is required between the 0 -1000 -1000

project periods, project 1 500 -500

2 400 -100
cash net flow and
3 300 200
cumulative Cash
4 200 400
Flow(CCF).
5 100 500
6 50 550
7 40 590
8 30 620
9 20 640
10 10 650
2/29/2016 Petroleum Economic 9

Solution of Example 1.0 (contd.)

Payout Period

CC𝐹n 100
=n+ =2+
FCn+1 300
= 2. 33 Years

2/29/2016 Petroleum Economic 10

© Farhad Khoshnaw 5
 29/02/2016

Discount Rate (DR%) or Discount Cash

Flow Rate of Return (DCFROR )
• Procedure:
– Calculate NPV @ various Discount Rate (DR) using the below
equation:
𝑛
𝐶𝐹
Rate Of Return = IRR = = NPV
(1 + 𝑖)𝑗
𝑗=0
• Where;
NPV = Net Present Value
CF = Cash Flow
IRR = Internal Rate of Return (Discounted Cash Flow Rate of
Return, DCFROR)

Therefore, it is required to calculate NPV at different rates and

plotted against the discount factor, and the value obtained for
discount factor at NPV = 0 is our IRR or DCFROR.

2/29/2016 Petroleum Economic 11

DCFROR for Project P

• NPV @ 0%
NPV
1000 500 400 300
=− + + +
1+0 0 1+0 1 1+0 2 1+0 3
200 100 50 40
+ + + +
1+0 4 1+0 5 1+0 6 1+0 7
30 20 10
+ + +
1+0 8 1+0 9 1 + 0 10

∴ NPVi=0% = $650

2/29/2016 Petroleum Economic 12

© Farhad Khoshnaw 6
 29/02/2016

DCFROR for Project P (contd.)

• Therefore same procedure was used for 5%,
10%, 15%, 20%, 25% and 30% to generate the
table below:

NPV ($) 650 446.12 284.30 153.18 45.07 -45.42 -122.17

DR (%) 0 5 10 15 20 25 30

2/29/2016 Petroleum Economic 13

DCFROR for Project P (contd.)

• Looking at previous Table the (0) Zero NPV is
between DR 20% & 25%, hereby, by mid point
interpolation, DR for (0) NPV can be
calculated:

NPV (X) DR% (Y)

45.07 20
0 X
- 45.42 25

2/29/2016 Petroleum Economic 14

© Farhad Khoshnaw 7
 29/02/2016

DCFROR for Project P (contd.)

• Mid Point Interpolation, for determining DR% when
NPV = 0
𝑋𝑚𝑎𝑥 − 𝑋𝑚𝑖𝑛 𝑌𝑚𝑎𝑥 − 𝑌𝑚𝑖𝑛
=
𝑋𝑚𝑖𝑑 − 𝑋𝑚𝑖𝑛 𝑌𝑚𝑖𝑑 − 𝑌𝑚𝑖𝑛
For project P:
45.07 − (−45.42) 20 − 25
=
0 − (−45.42) 𝑌𝑚𝑖𝑑 − 25

𝑌𝑚𝑖𝑑 =𝐷𝑅𝑁𝑃𝑉=0 = 22.49

2/29/2016 Petroleum Economic 15

Net Present Value (NPV)

• The net present value (NPV) or net present
worth profit is the algebraic sum of all net cash
flows when discounted to time zero using a
single, previously specified discounting rate.

• The rate to be considered in the calculations of

the Discount Factor is 5%, 10% and 15%.

2/29/2016 Petroleum Economic 16

© Farhad Khoshnaw 8
 29/02/2016

Net Present Value (NPV) Equation

1
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝐹𝑎𝑐𝑡𝑜𝑟 = 𝑗
1+𝑖

&
𝑛
1
𝑁𝑃𝑉 𝐶𝐹 ∗
(1 + 𝑖)𝑗
𝑗=0
Where;
CF = Cash Flow
i = Interest Rate (5%, 10% and 15%)
j = Discounted period (1, 2, 3…….10)

2/29/2016 Petroleum Economic 17

Project P
PROJECT - P
YEAR
CF DF @ 5% CF X DF DF @ 10% CF X DF DF @ 15% CF X DF
S
0 -1000 1 -1000 1 -1000 1 -1000
1 500 0.9524 476.1905 0.9091 454.5455 0.8696 434.7826
2 400 0.9070 362.8118 0.8264 330.5785 0.7561 302.4575
3 300 0.8638 259.1513 0.7513 225.3944 0.6575 197.2549
4 200 0.8227 164.5405 0.6830 136.6027 0.5718 114.3506
5 100 0.7835 78.3526 0.6209 62.0921 0.4972 49.7177
6 50 0.7462 37.3108 0.5645 28.2237 0.4323 21.6164
7 40 0.7107 28.4273 0.5132 20.5263 0.3759 15.0375
8 30 0.6768 20.3052 0.4665 13.9952 0.3269 9.8071
9 20 0.6446 12.8922 0.4241 8.4820 0.2843 5.6852
10 10 0.6139 6.1391 0.3855 3.8554 0.2472 2.4718
NPV 446.1212 284.2959 153.1813
2/29/2016 Petroleum Economic 18

© Farhad Khoshnaw 9
 29/02/2016

Calculation of the Future Value (FV)

Calculation of the future value of project P @ 10 %, 10 years:

From the NPV of project P, the NFV can be calculated through

using the following equations:

−𝐧
𝐍𝐏𝐕 = 𝐅𝐕 𝟏 + 𝐫
Where
FV= Net Future Value,
NPV= Net Present Value
r = Interest rate per period
n = Number of years (Project Period)

2/29/2016 Petroleum Economic 19

FV for Project, P

NPV i = 10% = 284.2959

n
→ FV = NPVi=10% × 1 + r

→ FVProject,P = 284.2959 × (1 + 0.1)10

= $737.4

2/29/2016 Petroleum Economic 20

© Farhad Khoshnaw 10
 29/02/2016

HOME WORK
1. Do the same
calculation for the
projects X & Y.

1. Rank the three projects (P,

X & Y) for capital
allocation, if only $3000 is
available for investment

2/29/2016 Petroleum Economic 21

End

Expected Value Concept

© Farhad Khoshnaw 11