Understanding Future Cash Flows
Valuation of Oil and Gas
Assets Understanding Future Cash Flows
Discussion Topics Time Value of Money • Future Value • Compound Interest
• Present Value • Discounting
Discount Rates • Cost of Capital Various Profitability Indices
Time Value of Money Because money can earn interest, it has a value dependent on time Assume we can get 10% annual interest Which of the following is the best option?
Now $100
1 Year $105
2 Years $120
The amount matters, but so does the time that the money will be received or spent.
Future Value Future value is the value in the future of an amount of money currently held Future value is calculated by compounding the present amount by a rate that accounts for the time value of money
FV = PV (1+i)n
Future Values FV = PV (1+i)n At the 10% interest rate Now $100
=
1 Year $110
=
2 Years $121 Future Value (FV)
Future values are worth less than present values of an equal sum
The second year, the interest was more than from the first year $10 and $11 Compounding
Compound Interest When interest is earned on the amount originally invested plus on interest previously earned, it is called compound interest Evaluations in Canada use the principle of compound interest
FV: Compound Interest N
Year
1
Year 1
FV1 = P(1+i)
2
Year 2
FV2 = P(1+i) (1+i)
3
Year 3
FV3 = P(1+i)(1+i)(1+i) or FV3 = P(1+i)3
4
Year 4
FV4 = P(1+i)4
n
Year n
FVn = P(1+i)n
Interest is paid at the end of each period
Formula
FVn = Value of Savings Bond P = Principal i = Interest Rate
FV: Compound Interest N
Year
Calculation
1
Year 1
A1 = $1000(1+0.1) = $1100
2
Year 2
A2 = 1000(1+0.1) (1+0.1) = $1210
3
Year 3
A3 = $1000(1+0.1)(1+0.1)(1+0.1) or A3 = $1000(1+.1)3 = $1331
4
Year 4
A4 = $1000(1+.1)4 = $1464
7
Year 7
A7 = $1000(1+0.1)7 = 1949
Future Value Example Future value of $1,000 in 7 years at 10% interest rate FV = PV(1+i)n n = 7, i = 10% (0.10), PV = $1,000
FV = $1,000x(1+.10)7 = $1949
Present Values At the 10% interest rate Now $100 Present Value (PV)
1 Year $110
2 Years $121 Future Value (FV)
Future values are worth less than present values of an equal sum
To properly value a cash flow stream, we need to determine valuation at a common point in time Called “Present Value” (PV)
Present Value Present value is the current economic equivalent of an amount of money to be received in the future Present value is calculated by discounting the future amount by a rate that accounts for the time value of money FV = PV (1+i)n
PV = FV/(1+i)n
Discount factor = 1/(1+i)n
Present Value Example What is the present value of $1,000 to be received 7 years from now with a 10% interest rate PV = FV/(1+i)n n = 7, i = 10% (0.10), PV = $1,000
PV PV PV PV
= = = =
$1,000/(1+.10)7 $1,000 * (1/1.949) $1,000 * 0.513 $513
Present Value Cash Flow Year
Future Value
Discount Factor
Present Value
1
$1000
0.91
$909
2
$1000
0.83
$826
3
$1000
0.75
$751
4
$1000
0.68
$683
5
$1000
0.62
$621
Totals
$5000
$3791
The discount factor is equal to 1/(1+i)n DF(1) = 1/(1+0.10)^1 = 0.909091 remember the first period is “1”
Discounting Discounting Reducing a sum of money in the future to determine its equivalent value now. Commonly done by using a discount factor. 1/(1+i)n Assumes that the cash flows occur at the end of the year. What if the cash flows will occur throughout the year?
Mid-Year Discounting Oil companies receive cash monthly Discounting monthly cash flow to the end of the year underestimates the value of the cash received before December A better approximation is to assume that the cash is collected in the middle of the year
Mid-year vs. End-year Discounting
Present Value Present Value (end-year) PV = FV (1+i)n Present Value (mid-year)
PV = FV (1+i)n-0.5
Mid-year vs. End-year Discounting Year
Future Value
End-Yr Discount Factor
Present Value
Mid-Yr Discount Factor
Present Value
1
$1000
0.91
$909
0.95
$953
2
$1000
0.83
$826
0.87
$867
3
$1000
0.75
$751
0.79
$788
4
$1000
0.68
$683
0.72
$716
5
$1000
0.62
$621
0.65
$651
Totals
$5000
$3791
$3976
The mid-year discount factor is equal to 1/(1+i) )n-0.5
Lottery - $25 Million Win Winner can choose to receive either Lump sum payment of $25 million Annual payments of $1 million for 25 years
What would be the right choice assuming a 2% annual inflation rate
Lottery - $25mm Win Payment 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
$ Received $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $25,000,000
Inflation 2% 1 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 0.660 0.647 0.634 0.622
Present Value $1,000,000 $980,392 $961,169 $942,322 $923,845 $905,731 $887,971 $870,560 $853,490 $836,755 $820,348 $804,263 $788,493 $773,033 $757,875 $743,015 $728,446 $714,163 $700,159 $686,431 $672,971 $659,776 $646,839 $634,156 $621,721 $19,913,926 -$5,086,074
Future Value $1,608,437 $1,576,899 $1,545,980 $1,515,666 $1,485,947 $1,456,811 $1,428,246 $1,400,241 $1,372,786 $1,345,868 $1,319,479 $1,293,607 $1,268,242 $1,243,374 $1,218,994 $1,195,093 $1,171,659 $1,148,686 $1,126,162 $1,104,081 $1,082,432 $1,061,208 $1,040,400 $1,020,000 $1,000,000 $32,030,300 $7,030,300
Lottery - $25 Million Win The PV of the 25 annual payments =
The PV of lump sum $25 million payment =
The FV of investing lump sum of $25 million =
The FV of the 25 annual payments =
Lottery - $25 Million Win The PV of the 25 annual payments = $19.9 million
The PV of lump sum $25 million payment = $25 million
The FV of investing lump sum of $25 million = $41.0 million
The FV of the 25 annual payments = $32.0 million
Take the $25 million lump sum payment and invest wisely!!
Evaluating Oil and Gas Assets using the Income Method Oil Rate Oil Prod Year bopd Mbbl
Barrels Per Month
Crown Oil Price Oil Revenue Royalty CAD/bbl M$ Percent
Crown Net Capital Fixed Op Variable Total Op Before Tax Royalties Revenue Cost Costs Wells Op Cost Cost Cash Flow M$ M$ M$ M$ M$ M$ M$
2016
147.7
49.3
4485
65.77
3244
5.0%
162
3082
2017
87.4
31.9
2658
76.18
2430
39.5%
961
2018
62.4
22.8
1898
84.14
1916
39.9%
2019
44.5
16.2
1354
85.75
1392
2020
31.7
11.6
967
88.08
2021
22.6
8.2
687
2022
16.2
5.9
2023
11.5
2024 2025 Total
Discount Discounted Before Tax Factor Cash Flow @10% M$
27.5
247
274
1,208
0.9535
1,152
1470
30
160
190
1,280
0.8668
1,110
764
1152
30
114
144
1,008
0.7880
795
36.2%
504
889
30
81
111
778
0.7163
557
1021
31.1%
318
704
30
58
88
616
0.6512
401
89.48
738
26.4%
195
543
30
41
71
472
0.5920
279
493
90.90
537
19.5%
105
432
30
30
60
373
0.5382
201
4.2
350
92.34
387
14.3%
55
332
30
21
51
281
0.4893
138
8.2
3.0
250
93.80
281
17.6%
49
232
30
15
45
187
0.4448
83
5.9
2.2
179
95.28
205
7.4%
15
190
30
11
41
149
0.4044
60
155.4
12,155
3,129
1,600
1,074
6,353
(Numbers may not total due to rounding)
4,776
What discount rate to use? Primary goal of a company: create value for shareholders Typically through value add projects Value determined by future cash flows Current value of a company is determined by the value of its anticipated future cash flows Need to calculate PV of future cash flows Need to use a discount rate to do so Appropriate discount rate determined by a company’s cost of capital
Cost of Capital Cost of raising funds Debt
Interest rate required by lenders
Equity
The return required by investors
Key driver of firm value If a company can reduce its cost of capital all potential investments become more attractive The required rate of return on firm’s investments in order to satisfy all investors
Weighted Average Cost of Capital (WACC) Company Capitalization = Debt + Shareholders’ Equity WACC = (WD * (1-TR) * KD + WSE * KSE) ; where
WD = % Capitalization that is Debt TR = Tax Rate KD = Cost of Debt WSE = % Capitalization that is Shareholder Equity KSE = After Tax Return on Shareholder Equity
Cost of Capital
Interest rate required by lenders
Determined by the terms of the loan
The return required by investors Basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors Theoretical methods exist to calculate an approximation of what the market expects Capital Asset Pricing Model (CAPM) Setting an actual target Arbitrary decision by Board of Directors
Consolidated Balance Sheet 2015
2014
$7,641
$6,622
$477
$703
$1,267
$919
Other Long Tem Liabilities
$179
$123
Deferred Income Taxes
$486
$422
Total Liabilities
$2,409
$2,167
Total Shareholder Equity
$5,232
$4,455
Total Liabilities & Equity
$7,641
$6,622
Effective Interest Rate
2.68%
2.93%
Effective Income Tax Rate
51.6%
26.9%
2%
11%
(As of December 31 $MM CDN)
Total Assets Current Liabilities Long Term Debt
After Tax Return on Shareholder Equity
Example WACC Calculation •Debt •Equity •Total
Capitalization $1,267 $5,232 $6,499
% 19.5 % 80.5 % 100 %
Cost 2.7 % ~11 %
Tax Rate: ~28 % WACC = (WD * (1-TR) * KD + WSE * KSE) WACC = ((19.5% * (1 - 0.28) * 2.7%) + (80.5% * 11%)) WACC = 9.2%
Wtd.-Avg. Cost of Capital (WACC) Capital Structure
20%
WACC
15% 10% 5% 0% 0%
Equity
Preferred
20%
40%
Debt
60%
% Debt
Assumed
Optimizing and managing debt levels • E & P companies prefer to minimize debt • Utility companies prefer to maximize debt
Actual
80%
100%
“Cost of capital key driver of firm value” Key driver of firm value If a company can reduce its cost of capital all potential investments become more attractive WACC is the required rate of return on firm’s investments in order to satisfy all investors Create value for shareholders Through value add projects (Operations) Achieve optimal capital structure (Finance)
Relative cost of debt vs. equity Risk Flexibility of future financing
Use of Profitability Indices Analyze investments Determine whether an investment will meet a profitability threshold Determine how much profit an investment will make Compare investments Decide which investment opportunities to pursue and which to defer or reject Rank investment opportunities Create budgets – top down then bottom up cycle Decide whether to make substitutions on budgeted projects Reduces ranking subjectivity
Evaluating Oil and Gas Assets using the Income Method Oil Rate Oil Prod Year bopd Mbbl
Barrels Per Month
Crown Oil Price Oil Revenue Royalty CAD/bbl M$ Percent
Crown Net Capital Fixed Op Variable Total Op Before Tax Royalties Revenue Cost Costs Wells Op Cost Cost Cash Flow M$ M$ M$ M$ M$ M$ M$
2016
147.7
49.3
4485
65.77
3244
5.0%
162
3082
2017
87.4
31.9
2658
76.18
2430
39.5%
961
2018
62.4
22.8
1898
84.14
1916
39.9%
2019
44.5
16.2
1354
85.75
1392
2020
31.7
11.6
967
88.08
2021
22.6
8.2
687
2022
16.2
5.9
2023
11.5
2024 2025 Total
Discount Discounted Before Tax Factor Cash Flow @10% M$
27.5
247
274
1,208
0.9535
1,152
1470
30
160
190
1,280
0.8668
1,110
764
1152
30
114
144
1,008
0.7880
795
36.2%
504
889
30
81
111
778
0.7163
557
1021
31.1%
318
704
30
58
88
616
0.6512
401
89.48
738
26.4%
195
543
30
41
71
472
0.5920
279
493
90.90
537
19.5%
105
432
30
30
60
373
0.5382
201
4.2
350
92.34
387
14.3%
55
332
30
21
51
281
0.4893
138
8.2
3.0
250
93.80
281
17.6%
49
232
30
15
45
187
0.4448
83
5.9
2.2
179
95.28
205
7.4%
15
190
30
11
41
149
0.4044
60
155.4
12,155
3,129
1,600
1,074
6,353
(Numbers may not total due to rounding)
4,776
Profitability Indices and Projects Net Present Value (NPV) Time to Payout (PO) Profit to Investment Ratio (PIR) Discounted Profit to Investment Ratio (DPIR) Internal Rate of Return (IRR) Netback F&D Costs Recycle Ratio Reserve Life Index
Net Present Value (NPV) Measures monetary value of an investment opportunity Discount after-tax profit for each year at the applicable discount rate Sum annual present values to determine net present value of the investment opportunity Used for valuation of opportunities, assets and companies Discount at company’s cost of capital Bigger is better - goal of the firm is to maximize after- tax net present value Considers time value of money
Present Value Present Value (mid-year) PV = FV (1+i)n-0.5 Where: FV = Future Value i = discount rate n = the number of periods (years) into the future that the cash flow occurs
NPV - Example Year
Revenue
OPEX
0
CAPEX
Net Cash Flow
Discount Factor @ 10%
NPV
$50,000
($50,000)
1.0000
($50,000)
1
$40,000
$10,000
$30,000
0.9535
$28,604
2
$30,000
$10,000
$20,000
0.8668
$17,336
3
$25,000
$10,000
$15,000
0.7880
$11,820
4
$20,000
$10,000
$10,000
0.7164
$7,164
5
$15,000
$10,000
$5,000
0.6512
$3,256
Total
$130,000
$50,000
$50,000
$30,000
NPV =
$18,179
Time to Payout (PO) Length of time needed to recoup the original investment from when the investment is made Calculate the cumulative net cash flow and estimate the time it takes to reach zero Assesses risk that the investor will get his money back Ignores time value of money Discounted PO incorporates time value of money
PO - Example Year
Net Cash Flow
Cumulative Net Cash Flow
Discount Factor @ 10%
Discounted Net Cash Flow
Discounted Cumulative Net Cash Flow
0
($50,000)
($50,000)
1.0000
($50,000)
($50,000)
1
$30,000
($20,000)
0.9535
$28,604
2
$20,000
$0
0.8668
$17,336
3
$15,000
$15,000
0.7880
$11,820
4
$10,000
$25,000
0.7164
$7,164
5
$5,000
$30,000
0.6512
$3,256
Total
$30,000
Payout =
NPV =
2.0 Years
($21,396) ($4,060) $7,759 $14,923 $18,179
$18,179
Payout =
2.34 Years
Profit to Investment Ratio (PIR) (Return on Investment) Total net profit divided by the investment Determined by: Calculate the total net cash flow Calculate the total investment Divide the total net cash flow by the total investment Assesses the risk that the project might not payout if prices decline or if production is lower than forecast “Bang for your buck” Ignores time value of money
Discounted Profit to Investment Ratio (DPIR) (Discounted Return on Investment) Ratio of the NPV of the cash flow to the NPV of the investment Capital efficiency metric Determined by: Divide the NPV by the NPV of the investment at similar discount rates Often used to rank investments Ensures portfolio generates maximum NPV for the company Considers time value of money
DPIR - Example CAPEX
Net Cash Flow
Discount Factor @ 10%
$50,000
($50,000)
$50,000
PIR=
NPV @ 10%
Discount Factor @ 15%
NPV @ 15%
Discount Factor @ 40%
NPV @ 40%
1
($50,000)
1
($50,000)
1
($50,000)
$30,000
0.9535
$28,604
0.9325
$27,975
0.8452
$25,355
$20,000
0.8668
$17,336
0.8109
$16,217
0.6037
$12,074
$15,000
0.7880
$11,820
0.7051
$10,577
0.4312
$6,468
$10,000
0.7164
$7,164
0.6131
$6,131
0.3080
$3,080
$5,000
0.6512
$3,256
0.5332
$2,666
0.2200
$1,100
NPV =
$13,566
NPV =
($1,924)
$30,000
NPV =
$18,179
0.6
DPIR =
0.36
DPIR =
0.27
DPIR =
-0.04
Internal Rate of Return (IRR) The internal rate of return (IRR) is the discount rate at which the NPV of the cash flow is equal to zero IRR can be described as the rate of growth a project is expected to generate Determined by: Determine the net present value of the cash flows using various discount rates until the net present value equals zero. Practically, use interpolation (Goal Seek in Excel) to find the rate at which the net present value equals zero Used as a threshold indicator Companies generally do not invest in projects that have a IRR less than their cost of capital Considers time value of money
IRR - Example CAPEX
Net Cash Flow
Discount Factor @ 10%
$50,000
($50,000)
$50,000
NPV @ 10%
Discount Factor @ 15%
NPV @ 15%
Discount Factor @ 40%
NPV @ 40%
1
($50,000)
1
($50,000)
1
($50,000)
$30,000
0.9535
$28,604
0.9325
$27,975
0.8452
$25,355
$20,000
0.8668
$17,336
0.8109
$16,217
0.6037
$12,074
$15,000
0.7880
$11,820
0.7051
$10,577
0.4312
$6,468
$10,000
0.7164
$7,164
0.6131
$6,131
0.3080
$3,080
$5,000
0.6512
$3,256
0.5332
$2,666
0.2200
$1,100
$18,179
NPV =
$13,566
NPV =
($1,924)
$30,000 Positive
NPV =
Positive
Positive
Negative
IRR - Example $40,000
Net Present Value
$30,000
$20,000
$10,000
IRR = 36%
$0 0 -$10,000
10
20
Discount Rate %
30
40
Comparing Equal $1,000 Investments
Net Present Value $
4000 3000 2000 1000 0
0
5
10
15
-1000 -2000
Discount Rate %
A
B
C
D
E
20
25
Knowledge Check Comparing Investments - Solution Investment
IRR
PIR
DPIR @ 10%
A
15%
3000/1000 = 3.0
1000/1000 = 1.0
B
18%
2000/1000 = 2.0
1600/1000 = 1.6
C
20%
1500/1000 = 1.5
500/1000 = 0.5
D
5%
1200/1000 = 1.2
(800)/1000 = (0.8)
E
25%
1000/1000 = 1.0
600/1000 = 0.6
Which Project is the Best Investment Opportunity? – Project B
Operating Netback How much money is being made per unit of production
Operating Netback = (Revenue – Royalties – Opex) Production
Strength: easy to calculate Weakness: Doesn’t consider the time value of money Doesn’t consider asset type; not neutral
Finding & Development Costs (F&D) Cost of adding a unit of new reserves
F&D = Capital to find & bring reserves on production Reserves Added
Can be calculated for any basis Total Proven F&D Total Proven plus Probable F&D PUD F&D Current year capital program F&D Corporate 3 year average F&D
Recycle Ratio Netback/F&D Ratio of profit to cost For each BOE produced, profit vs. cost to replace The higher the recycle ratio the more profitable the company
Doesn’t consider the time value of money Uncertainty in what is included in F&D costs
Reserve Life Index Ratio of reserves to current production Reserve Life Index (RLI) = Reserves Current Production Strength: Useful check Used for assessing risk Weakness Doesn’t consider asset type (heavy oil production incline, horizontal steep 1st year production decline)
Profitability Indices There is no perfect profitability index All have strengths and weaknesses Selecting the appropriate profitability indices to use for analyzing and ranking investments requires experience and good judgment Proper analysis of projects is the key to ensuring corporate goals are met
Assets Understanding Future Cash Flows
Discussion Topics Time Value of Money • Future Value • Compound Interest
• Present Value • Discounting
Discount Rates • Cost of Capital Various Profitability Indices
Time Value of Money Because money can earn interest, it has a value dependent on time Assume we can get 10% annual interest Which of the following is the best option?
Now $100
1 Year $105
2 Years $120
The amount matters, but so does the time that the money will be received or spent.
Future Value Future value is the value in the future of an amount of money currently held Future value is calculated by compounding the present amount by a rate that accounts for the time value of money
FV = PV (1+i)n
Future Values FV = PV (1+i)n At the 10% interest rate Now $100
=
1 Year $110
=
2 Years $121 Future Value (FV)
Future values are worth less than present values of an equal sum
The second year, the interest was more than from the first year $10 and $11 Compounding
Compound Interest When interest is earned on the amount originally invested plus on interest previously earned, it is called compound interest Evaluations in Canada use the principle of compound interest
FV: Compound Interest N
Year
1
Year 1
FV1 = P(1+i)
2
Year 2
FV2 = P(1+i) (1+i)
3
Year 3
FV3 = P(1+i)(1+i)(1+i) or FV3 = P(1+i)3
4
Year 4
FV4 = P(1+i)4
n
Year n
FVn = P(1+i)n
Interest is paid at the end of each period
Formula
FVn = Value of Savings Bond P = Principal i = Interest Rate
FV: Compound Interest N
Year
Calculation
1
Year 1
A1 = $1000(1+0.1) = $1100
2
Year 2
A2 = 1000(1+0.1) (1+0.1) = $1210
3
Year 3
A3 = $1000(1+0.1)(1+0.1)(1+0.1) or A3 = $1000(1+.1)3 = $1331
4
Year 4
A4 = $1000(1+.1)4 = $1464
7
Year 7
A7 = $1000(1+0.1)7 = 1949
Future Value Example Future value of $1,000 in 7 years at 10% interest rate FV = PV(1+i)n n = 7, i = 10% (0.10), PV = $1,000
FV = $1,000x(1+.10)7 = $1949
Present Values At the 10% interest rate Now $100 Present Value (PV)
1 Year $110
2 Years $121 Future Value (FV)
Future values are worth less than present values of an equal sum
To properly value a cash flow stream, we need to determine valuation at a common point in time Called “Present Value” (PV)
Present Value Present value is the current economic equivalent of an amount of money to be received in the future Present value is calculated by discounting the future amount by a rate that accounts for the time value of money FV = PV (1+i)n
PV = FV/(1+i)n
Discount factor = 1/(1+i)n
Present Value Example What is the present value of $1,000 to be received 7 years from now with a 10% interest rate PV = FV/(1+i)n n = 7, i = 10% (0.10), PV = $1,000
PV PV PV PV
= = = =
$1,000/(1+.10)7 $1,000 * (1/1.949) $1,000 * 0.513 $513
Present Value Cash Flow Year
Future Value
Discount Factor
Present Value
1
$1000
0.91
$909
2
$1000
0.83
$826
3
$1000
0.75
$751
4
$1000
0.68
$683
5
$1000
0.62
$621
Totals
$5000
$3791
The discount factor is equal to 1/(1+i)n DF(1) = 1/(1+0.10)^1 = 0.909091 remember the first period is “1”
Discounting Discounting Reducing a sum of money in the future to determine its equivalent value now. Commonly done by using a discount factor. 1/(1+i)n Assumes that the cash flows occur at the end of the year. What if the cash flows will occur throughout the year?
Mid-Year Discounting Oil companies receive cash monthly Discounting monthly cash flow to the end of the year underestimates the value of the cash received before December A better approximation is to assume that the cash is collected in the middle of the year
Mid-year vs. End-year Discounting
Present Value Present Value (end-year) PV = FV (1+i)n Present Value (mid-year)
PV = FV (1+i)n-0.5
Mid-year vs. End-year Discounting Year
Future Value
End-Yr Discount Factor
Present Value
Mid-Yr Discount Factor
Present Value
1
$1000
0.91
$909
0.95
$953
2
$1000
0.83
$826
0.87
$867
3
$1000
0.75
$751
0.79
$788
4
$1000
0.68
$683
0.72
$716
5
$1000
0.62
$621
0.65
$651
Totals
$5000
$3791
$3976
The mid-year discount factor is equal to 1/(1+i) )n-0.5
Lottery - $25 Million Win Winner can choose to receive either Lump sum payment of $25 million Annual payments of $1 million for 25 years
What would be the right choice assuming a 2% annual inflation rate
Lottery - $25mm Win Payment 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
$ Received $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $25,000,000
Inflation 2% 1 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 0.660 0.647 0.634 0.622
Present Value $1,000,000 $980,392 $961,169 $942,322 $923,845 $905,731 $887,971 $870,560 $853,490 $836,755 $820,348 $804,263 $788,493 $773,033 $757,875 $743,015 $728,446 $714,163 $700,159 $686,431 $672,971 $659,776 $646,839 $634,156 $621,721 $19,913,926 -$5,086,074
Future Value $1,608,437 $1,576,899 $1,545,980 $1,515,666 $1,485,947 $1,456,811 $1,428,246 $1,400,241 $1,372,786 $1,345,868 $1,319,479 $1,293,607 $1,268,242 $1,243,374 $1,218,994 $1,195,093 $1,171,659 $1,148,686 $1,126,162 $1,104,081 $1,082,432 $1,061,208 $1,040,400 $1,020,000 $1,000,000 $32,030,300 $7,030,300
Lottery - $25 Million Win The PV of the 25 annual payments =
The PV of lump sum $25 million payment =
The FV of investing lump sum of $25 million =
The FV of the 25 annual payments =
Lottery - $25 Million Win The PV of the 25 annual payments = $19.9 million
The PV of lump sum $25 million payment = $25 million
The FV of investing lump sum of $25 million = $41.0 million
The FV of the 25 annual payments = $32.0 million
Take the $25 million lump sum payment and invest wisely!!
Evaluating Oil and Gas Assets using the Income Method Oil Rate Oil Prod Year bopd Mbbl
Barrels Per Month
Crown Oil Price Oil Revenue Royalty CAD/bbl M$ Percent
Crown Net Capital Fixed Op Variable Total Op Before Tax Royalties Revenue Cost Costs Wells Op Cost Cost Cash Flow M$ M$ M$ M$ M$ M$ M$
2016
147.7
49.3
4485
65.77
3244
5.0%
162
3082
2017
87.4
31.9
2658
76.18
2430
39.5%
961
2018
62.4
22.8
1898
84.14
1916
39.9%
2019
44.5
16.2
1354
85.75
1392
2020
31.7
11.6
967
88.08
2021
22.6
8.2
687
2022
16.2
5.9
2023
11.5
2024 2025 Total
Discount Discounted Before Tax Factor Cash Flow @10% M$
27.5
247
274
1,208
0.9535
1,152
1470
30
160
190
1,280
0.8668
1,110
764
1152
30
114
144
1,008
0.7880
795
36.2%
504
889
30
81
111
778
0.7163
557
1021
31.1%
318
704
30
58
88
616
0.6512
401
89.48
738
26.4%
195
543
30
41
71
472
0.5920
279
493
90.90
537
19.5%
105
432
30
30
60
373
0.5382
201
4.2
350
92.34
387
14.3%
55
332
30
21
51
281
0.4893
138
8.2
3.0
250
93.80
281
17.6%
49
232
30
15
45
187
0.4448
83
5.9
2.2
179
95.28
205
7.4%
15
190
30
11
41
149
0.4044
60
155.4
12,155
3,129
1,600
1,074
6,353
(Numbers may not total due to rounding)
4,776
What discount rate to use? Primary goal of a company: create value for shareholders Typically through value add projects Value determined by future cash flows Current value of a company is determined by the value of its anticipated future cash flows Need to calculate PV of future cash flows Need to use a discount rate to do so Appropriate discount rate determined by a company’s cost of capital
Cost of Capital Cost of raising funds Debt
Interest rate required by lenders
Equity
The return required by investors
Key driver of firm value If a company can reduce its cost of capital all potential investments become more attractive The required rate of return on firm’s investments in order to satisfy all investors
Weighted Average Cost of Capital (WACC) Company Capitalization = Debt + Shareholders’ Equity WACC = (WD * (1-TR) * KD + WSE * KSE) ; where
WD = % Capitalization that is Debt TR = Tax Rate KD = Cost of Debt WSE = % Capitalization that is Shareholder Equity KSE = After Tax Return on Shareholder Equity
Cost of Capital
Interest rate required by lenders
Determined by the terms of the loan
The return required by investors Basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors Theoretical methods exist to calculate an approximation of what the market expects Capital Asset Pricing Model (CAPM) Setting an actual target Arbitrary decision by Board of Directors
Consolidated Balance Sheet 2015
2014
$7,641
$6,622
$477
$703
$1,267
$919
Other Long Tem Liabilities
$179
$123
Deferred Income Taxes
$486
$422
Total Liabilities
$2,409
$2,167
Total Shareholder Equity
$5,232
$4,455
Total Liabilities & Equity
$7,641
$6,622
Effective Interest Rate
2.68%
2.93%
Effective Income Tax Rate
51.6%
26.9%
2%
11%
(As of December 31 $MM CDN)
Total Assets Current Liabilities Long Term Debt
After Tax Return on Shareholder Equity
Example WACC Calculation •Debt •Equity •Total
Capitalization $1,267 $5,232 $6,499
% 19.5 % 80.5 % 100 %
Cost 2.7 % ~11 %
Tax Rate: ~28 % WACC = (WD * (1-TR) * KD + WSE * KSE) WACC = ((19.5% * (1 - 0.28) * 2.7%) + (80.5% * 11%)) WACC = 9.2%
Wtd.-Avg. Cost of Capital (WACC) Capital Structure
20%
WACC
15% 10% 5% 0% 0%
Equity
Preferred
20%
40%
Debt
60%
% Debt
Assumed
Optimizing and managing debt levels • E & P companies prefer to minimize debt • Utility companies prefer to maximize debt
Actual
80%
100%
“Cost of capital key driver of firm value” Key driver of firm value If a company can reduce its cost of capital all potential investments become more attractive WACC is the required rate of return on firm’s investments in order to satisfy all investors Create value for shareholders Through value add projects (Operations) Achieve optimal capital structure (Finance)
Relative cost of debt vs. equity Risk Flexibility of future financing
Use of Profitability Indices Analyze investments Determine whether an investment will meet a profitability threshold Determine how much profit an investment will make Compare investments Decide which investment opportunities to pursue and which to defer or reject Rank investment opportunities Create budgets – top down then bottom up cycle Decide whether to make substitutions on budgeted projects Reduces ranking subjectivity
Evaluating Oil and Gas Assets using the Income Method Oil Rate Oil Prod Year bopd Mbbl
Barrels Per Month
Crown Oil Price Oil Revenue Royalty CAD/bbl M$ Percent
Crown Net Capital Fixed Op Variable Total Op Before Tax Royalties Revenue Cost Costs Wells Op Cost Cost Cash Flow M$ M$ M$ M$ M$ M$ M$
2016
147.7
49.3
4485
65.77
3244
5.0%
162
3082
2017
87.4
31.9
2658
76.18
2430
39.5%
961
2018
62.4
22.8
1898
84.14
1916
39.9%
2019
44.5
16.2
1354
85.75
1392
2020
31.7
11.6
967
88.08
2021
22.6
8.2
687
2022
16.2
5.9
2023
11.5
2024 2025 Total
Discount Discounted Before Tax Factor Cash Flow @10% M$
27.5
247
274
1,208
0.9535
1,152
1470
30
160
190
1,280
0.8668
1,110
764
1152
30
114
144
1,008
0.7880
795
36.2%
504
889
30
81
111
778
0.7163
557
1021
31.1%
318
704
30
58
88
616
0.6512
401
89.48
738
26.4%
195
543
30
41
71
472
0.5920
279
493
90.90
537
19.5%
105
432
30
30
60
373
0.5382
201
4.2
350
92.34
387
14.3%
55
332
30
21
51
281
0.4893
138
8.2
3.0
250
93.80
281
17.6%
49
232
30
15
45
187
0.4448
83
5.9
2.2
179
95.28
205
7.4%
15
190
30
11
41
149
0.4044
60
155.4
12,155
3,129
1,600
1,074
6,353
(Numbers may not total due to rounding)
4,776
Profitability Indices and Projects Net Present Value (NPV) Time to Payout (PO) Profit to Investment Ratio (PIR) Discounted Profit to Investment Ratio (DPIR) Internal Rate of Return (IRR) Netback F&D Costs Recycle Ratio Reserve Life Index
Net Present Value (NPV) Measures monetary value of an investment opportunity Discount after-tax profit for each year at the applicable discount rate Sum annual present values to determine net present value of the investment opportunity Used for valuation of opportunities, assets and companies Discount at company’s cost of capital Bigger is better - goal of the firm is to maximize after- tax net present value Considers time value of money
Present Value Present Value (mid-year) PV = FV (1+i)n-0.5 Where: FV = Future Value i = discount rate n = the number of periods (years) into the future that the cash flow occurs
NPV - Example Year
Revenue
OPEX
0
CAPEX
Net Cash Flow
Discount Factor @ 10%
NPV
$50,000
($50,000)
1.0000
($50,000)
1
$40,000
$10,000
$30,000
0.9535
$28,604
2
$30,000
$10,000
$20,000
0.8668
$17,336
3
$25,000
$10,000
$15,000
0.7880
$11,820
4
$20,000
$10,000
$10,000
0.7164
$7,164
5
$15,000
$10,000
$5,000
0.6512
$3,256
Total
$130,000
$50,000
$50,000
$30,000
NPV =
$18,179
Time to Payout (PO) Length of time needed to recoup the original investment from when the investment is made Calculate the cumulative net cash flow and estimate the time it takes to reach zero Assesses risk that the investor will get his money back Ignores time value of money Discounted PO incorporates time value of money
PO - Example Year
Net Cash Flow
Cumulative Net Cash Flow
Discount Factor @ 10%
Discounted Net Cash Flow
Discounted Cumulative Net Cash Flow
0
($50,000)
($50,000)
1.0000
($50,000)
($50,000)
1
$30,000
($20,000)
0.9535
$28,604
2
$20,000
$0
0.8668
$17,336
3
$15,000
$15,000
0.7880
$11,820
4
$10,000
$25,000
0.7164
$7,164
5
$5,000
$30,000
0.6512
$3,256
Total
$30,000
Payout =
NPV =
2.0 Years
($21,396) ($4,060) $7,759 $14,923 $18,179
$18,179
Payout =
2.34 Years
Profit to Investment Ratio (PIR) (Return on Investment) Total net profit divided by the investment Determined by: Calculate the total net cash flow Calculate the total investment Divide the total net cash flow by the total investment Assesses the risk that the project might not payout if prices decline or if production is lower than forecast “Bang for your buck” Ignores time value of money
Discounted Profit to Investment Ratio (DPIR) (Discounted Return on Investment) Ratio of the NPV of the cash flow to the NPV of the investment Capital efficiency metric Determined by: Divide the NPV by the NPV of the investment at similar discount rates Often used to rank investments Ensures portfolio generates maximum NPV for the company Considers time value of money
DPIR - Example CAPEX
Net Cash Flow
Discount Factor @ 10%
$50,000
($50,000)
$50,000
PIR=
NPV @ 10%
Discount Factor @ 15%
NPV @ 15%
Discount Factor @ 40%
NPV @ 40%
1
($50,000)
1
($50,000)
1
($50,000)
$30,000
0.9535
$28,604
0.9325
$27,975
0.8452
$25,355
$20,000
0.8668
$17,336
0.8109
$16,217
0.6037
$12,074
$15,000
0.7880
$11,820
0.7051
$10,577
0.4312
$6,468
$10,000
0.7164
$7,164
0.6131
$6,131
0.3080
$3,080
$5,000
0.6512
$3,256
0.5332
$2,666
0.2200
$1,100
NPV =
$13,566
NPV =
($1,924)
$30,000
NPV =
$18,179
0.6
DPIR =
0.36
DPIR =
0.27
DPIR =
-0.04
Internal Rate of Return (IRR) The internal rate of return (IRR) is the discount rate at which the NPV of the cash flow is equal to zero IRR can be described as the rate of growth a project is expected to generate Determined by: Determine the net present value of the cash flows using various discount rates until the net present value equals zero. Practically, use interpolation (Goal Seek in Excel) to find the rate at which the net present value equals zero Used as a threshold indicator Companies generally do not invest in projects that have a IRR less than their cost of capital Considers time value of money
IRR - Example CAPEX
Net Cash Flow
Discount Factor @ 10%
$50,000
($50,000)
$50,000
NPV @ 10%
Discount Factor @ 15%
NPV @ 15%
Discount Factor @ 40%
NPV @ 40%
1
($50,000)
1
($50,000)
1
($50,000)
$30,000
0.9535
$28,604
0.9325
$27,975
0.8452
$25,355
$20,000
0.8668
$17,336
0.8109
$16,217
0.6037
$12,074
$15,000
0.7880
$11,820
0.7051
$10,577
0.4312
$6,468
$10,000
0.7164
$7,164
0.6131
$6,131
0.3080
$3,080
$5,000
0.6512
$3,256
0.5332
$2,666
0.2200
$1,100
$18,179
NPV =
$13,566
NPV =
($1,924)
$30,000 Positive
NPV =
Positive
Positive
Negative
IRR - Example $40,000
Net Present Value
$30,000
$20,000
$10,000
IRR = 36%
$0 0 -$10,000
10
20
Discount Rate %
30
40
Comparing Equal $1,000 Investments
Net Present Value $
4000 3000 2000 1000 0
0
5
10
15
-1000 -2000
Discount Rate %
A
B
C
D
E
20
25
Knowledge Check Comparing Investments - Solution Investment
IRR
PIR
DPIR @ 10%
A
15%
3000/1000 = 3.0
1000/1000 = 1.0
B
18%
2000/1000 = 2.0
1600/1000 = 1.6
C
20%
1500/1000 = 1.5
500/1000 = 0.5
D
5%
1200/1000 = 1.2
(800)/1000 = (0.8)
E
25%
1000/1000 = 1.0
600/1000 = 0.6
Which Project is the Best Investment Opportunity? – Project B
Operating Netback How much money is being made per unit of production
Operating Netback = (Revenue – Royalties – Opex) Production
Strength: easy to calculate Weakness: Doesn’t consider the time value of money Doesn’t consider asset type; not neutral
Finding & Development Costs (F&D) Cost of adding a unit of new reserves
F&D = Capital to find & bring reserves on production Reserves Added
Can be calculated for any basis Total Proven F&D Total Proven plus Probable F&D PUD F&D Current year capital program F&D Corporate 3 year average F&D
Recycle Ratio Netback/F&D Ratio of profit to cost For each BOE produced, profit vs. cost to replace The higher the recycle ratio the more profitable the company
Doesn’t consider the time value of money Uncertainty in what is included in F&D costs
Reserve Life Index Ratio of reserves to current production Reserve Life Index (RLI) = Reserves Current Production Strength: Useful check Used for assessing risk Weakness Doesn’t consider asset type (heavy oil production incline, horizontal steep 1st year production decline)
Profitability Indices There is no perfect profitability index All have strengths and weaknesses Selecting the appropriate profitability indices to use for analyzing and ranking investments requires experience and good judgment Proper analysis of projects is the key to ensuring corporate goals are met
