Net present values

The net present value (NPV) is one of the key terms in the appraisal technique - it refers to the difference between the present values of all costs and that of all revenues  

The NPV is calculated at a particular value of the DF, but the value corresponding to DF = 0, i.e. the base case, just looking at the simple, undiscounted sums of costs and revenues, is a useful figure also. 

All other things being equal, the project showing the highest value of NPV at a particular value of the DF (including zero) will be the most attractive, financially. 

The value of the DF to be used in the discounting formulae is chosen according to the purpose of the calculation. If the purpose is to demonstrate a positive NPV, or to compare NPVs for different projects, then a value will be chosen to match the company s own finances, and the value could then be 

NPV uses the concept of present value. Present value implies a dollar in your pocket today is worth more than receiving a dollar tomorrow. Three reasons explain this (1) risk, (2) inflation, and (3) opportunity cost. 

Risk There is a risk that you will not see your cash again. Some projects have a higher probability of failing or not providing cash inflows than were expected. 

Inflation Inflation cuts into your purchasing power. Today, you can buy 1 worth of goods, but with a 3% yearly inflation rate, next year you can only buy 0.97 worth of goods with 1. 

For a new project, management typically spends money in the beginning stages this is labeled as cash outflow or negative cash flow. Management does not increase shareholder wealth with cash outflows. The company hopes to reap rewards from the project and collect cash later. Generating cash from the project is labeled as cash inflow or positive cash flow. This is when the company generates value and wealth for itself and its shareholders. 

When using NPV for decision making, there is a need to provide an appropriate discount rate and an accurate estimate of future operating cash flows. The discount rate is a rate that is assigned based on the risk of the project and the cost of capital. The risk of a project is related to the possibility that future cash flows will be less than anticipated. If a risky project is undertaken, there must be a higher reward for taking it on. The discount rate will be higher for riskier projects. Further, if the cost of capital is 10%, the project needs to at least earn that amount to ensure all investors earn a return commensurate with their risk. 

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Net present value (NPV). Since money can be invested to earn interest, money received now has a greater present value than money received at some time in the future. The net present value of a project is the sum of the present values of each individual cash flow. In this case, the present is taken to be the start of a project. 

The sum of the annual discounted cash flows over n years SAdcf is known as the net present value (NPV) of the project ... 

Appraisal activity, if performed, is the step in the field life cycle between the discovery of a hydrocarbon accumulation and its development. The role of appraisal is to provide cost-effective information with which the subsequent decision can be made. Cost effective means that the value of the decision with the appraisal information is greater than the value of the decision without the information. If the appraisal activity does not add more value than its cost, then it is not worth doing. This can be represented by a simple flow diagram, in which the cost of appraisal is A, the profit (net present value) of the development with the appraisal information is (D2-A), and the profit of the development without the appraisal information is D1. 

Figure 7.1 Net present value with and without appraisal...

The type of development, type and number of development wells, recovery factor and production profile are all inter-linked. Their dependency may be estimated using the above approach, but lends itself to the techniques of reservoir simulation introduced in Section 8.4. There is never an obvious single development plan for a field, and the optimum plan also involves the cost of the surface facilities required. The decision as to which development plan is the best is usually based on the economic criterion of profitability. Figure 9.1 represents a series of calculations, aimed at determining the optimum development plan (the one with the highest net present value, as defined in Section 13). 

Keywords economic model, shareholder s profit, project cashflow, gross revenue, discounted cashflow, opex, capex, technical cost, tax, royalty, oil price, marker crude, capital allowance, discount rate, profitability indicators, net present value, rate of return, screening, ranking, expected monetary value, exploration decision making. 

The total undiscounted cash surplus (the ultimate cash surplus) is 190 m. The total discounted cash surplus ( 24.8 m) is called the net present value (NPV) of the project. Since in this example the discount rate applied is 20%, this figure would be the 20% NPV also annotated NPV(20). This is the present value at the beginning of Year 1 of the total project, assuming a 20% discount rate. 

At a specific discount rate the net present value (NPV) is reduced to zero. This discount rate is called the internal rate of return (IRR). 

Artificial lift techniques are discussed in Section 9.6. During production, the operating conditions of any artificial lift technique will be optimised with the objective of maximising production. For example, the optimum gas-liquid ratio will be applied for gas lifting, possibly using computer assisted operations (CAO) as discussed in Section 11.2. Artificial lift may not be installed from the beginning of a development, but at the point where the natural drive energy of the reservoir has reduced. The implementation of artificial lift will be justified, like any other incremental project, on the basis of a positive net present value (see Section 13.4). 

Wells are worked over to increase production, reduce operating cost or reinstate their technical integrity. In terms of economics alone (neglecting safety aspects) a workover can be justified if the net present value of the workover activity is positive (and assuming no other constraints exist). The appropriate discount rate is the company s cost of capital. 

Net Present Va.Iue, Each of the net annual cash flows can be discounted to the present time using a discount factor for the number of years involved. The discounted flows are then all at the same time point and can be combined. The sum of these discounted net flows is called the net present value (NPV), a popular profit criterion. Because the discounted positive flows first offset the negative investment flows in the NPV summation, the investment capital is recovered if the NPV is greater than zero. This early recovery of the investment does not correspond to typical capital recovery patterns, but gives a conservative and systematic assumption for investment recovery. 

The relationships among the various annual costs given by Eqs. (9-1) through (9-9) are illustrated diagrammaticaUy in Fig. 9-1. The top half of the diagram shows the tools of the accountant the bottom half, those of the engineer. The net annual cash flow Acp, which excludes any provision for balance-sheet depreciation Abd, is used in two of the more modern methods of profitability assessment the net-present-value (NPV) method and the discounted-cash-flow-rate-of-return (DCFRR) method. In both methods, depreciation is inherently taken care of by calculations which include capital recoveiy. 

FIG. 9-1 Relationship between annual costs, annual profits, and cash flows for a project. A d — annual depreciation allowance Acf — annual net cash flow after tax Ac/ = annual cash income Age = annual general expense Aqp = annual gross profit A/r = annual tax A e = annual manufacturing cost Avc/ = annual net cash income Avvp = annual net profit after taxes A/ p = annual net profit As = annual sales Apc = annual total cost (DCFRR) = discoiinted-cash-flow rate of return (NPV) = net present value. 

The ways of assessing profitabihty to be considered in this section are (1) discounted-cash-flow rate of return (DCFRR), (2) net present value (NPV) based on a particiilar discount rate, (3) eqmvalent maximum investment period (EMIP), (4) interest-recovery period (IRP), and (5) discounted breakeven point (DEEP). 

Example 2 Net Present Value for Different Depreciation Methods The following data descrihe a project. Revenue from annual sales and the total annual expense over a 10-year period are given in the first three columns of Table 9-5. The fixed-capital investment Cpc is 1,000,000. Plant items have a zero salvage value. Working capital C vc is 90,000, and cost of land C/ is 10,000. There are no tax allowances other than depreciation i.e., is zero. The fractional tax rate t is 0.50. 

The net present value (NPV) is found hy summing the values of Adcf for each year, as in Eq. (9-53). The net present value is found to he 276,210, as given hy the final entry in Table 9-5. 

Adcf — net annual discounted cash flow. (NPV) = Z Adcf = net present value. 

Increasing use is being made of the capital-rate-of-return ratio (CRR), whiA is the net present value (NPV) divided by the maximum cumulative expenditure or maximum net outlay, -(S CF)max... 

It is possible for some projects to reach a stage at which repairs, replacements, etc., can exceed net earnings in a particular year. In this case the cumulative-discounted-cash-flow or net-present-value curve plotted against time has a genuine maximum. 

Comparisons on the basis of interest can be summarized as (1) the net present value (NPV) and (2) the discounted-cash-flow rate of return (DCFRR), which from Eqs. (9-53) and (9-54) is given formally as the fractional interest rate i which satisfies the relationship... 

The net annual cash flows Acp and cumulative discounted annual cash flow X Aocf discount factor of 10 percent are hsted in Table 9-7 for the two projec ts. At the end of Year 9, the net present values are... 

For this simphfied case the net present value (NPV) after n years with money invested at a required aftertax compound annual fractional interest rate i is given by the equation... 

FIG. 9-14 Net present value against time, showing effect of adverse changes in cash flows. 

We shall use these data and the accompanying information of Table 9-5 as the base case and calculate for straight-line depreciation the net present value (NPV) with a 10 percent discount factor and the discoiinted-cash-flow rate of return (DCFRR) for the project with the following situations. 

As = base revenue from annual sales before tax. Ate = base total annual expense before tax. (NPV) = base net present value after tax. 

AAdcf — decrease in net discounted cash flow at income tax rate = 0.5. A(NPV) = 2- AAqcf — decrease in net present value. 

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