Instructional Objectives

You will be able to

Name the major yardsticks used to
measure economic benefit and to
make economic decisions
Calculate ROR, NPR, DPI, and payout.

Time Value of Money

Time Value of Money

Time Value of Money

Time Value of Money

Time Value of Money

Time Value of Money

Time Value of Money

Time
Banking and interest reduce amount
$1 will buy
$1 will buy more now than next year
Cost of use (interest)
Lenders charge fee for use of money
Longer payback = higher total interest

Economic Yardsticks
Measures that do not Measures that do
consider the time value
consider the time
of money
value of money
Profit
Payout
Cost to find,
develop reserves

Rate of Return (ir

or ROR)
Net Present Value
(Ppv or NPV)
Discounted Profitto
Investment Ratio
(DPI)

Profit

Money taken in

Money going out

intial investment
capital expenses
operating costs
taxes

Payout
Time from investment
to positive net cash
flow

Usually easy to calculate

Can be days to several years
Time of payout may be criterion
for investment

Cost of Finding Reserves

To find and
develop
reserves

( $/bbl or $/Mscf )
General measure for comparing
exploration opportunities

Example 1

Restoring a Well to Production

A well in north Africa is shut in after it can
no longer flow naturally. After several
years, a recompletion is proposed at a cost
of US$750,000. After a fracture stimulation
and installation of gas lift, the well is
successfully returned to production.

Calculate the total profit, payout, and

cost to find and develop reserves.

Example 1

Restoring a Well to Production

Year
Flow

Revenue
Cash Flow Expenses
M$
M$

0
1
500
2
500
3
400
7 years4of production
300
5
200
6
100
7
50

50
50
60
60
70
70
20

Taxes
M$
225
225
170
120
65
15
15

Net
Investment Cash Flow
M$
M$
750
-750
225
225
170
120
65
15
15

Cumulative Oil Production during 7 years = 200,000 bbls

Example 1

Restoring a Well to Production

Year
Flow
0
1
2
3
4
5
6
7
TOTAL

Revenue
Cash Flow Expenses
M$
M$

Taxes
M$

500
500
400
300
200
100
50

50
50
60
60
70
70
20

225
225
170
120
65
15
15

2,050

380

835

Investment
M$
750

750

Total Profit = US $ 85,000

Net
Cash Flow
M$
-750
225
225
170
120
65
15
15
85

Cum
Cash Flow
M$
-750
-525
-300
-130
-10
55
70
85

Example 1

Restoring a Well to Production

Year
Flow
0
1
2
3
4
5
6
7
TOTAL

Revenue
Cash Flow Expenses
M$
M$
500
500
400
300
200
100
50

50
50
60
60
70
70
20

2,050

380

Taxes
M$

Investment
M$
750

225
225
170
120
65
15
15

Net
Cash Flow
M$
-750
225
225
170
120
65
15
15

Cum
Cash Flow
M$
-750
-525
-300
-130
-10
55
70
85

Cumulative net cash flow

initial investment
835

750

Payout is roughly 4.15 years

85

Example 1

Restoring a Well to Production

Year
Flow
0
1
2
3
4
5
6
7
TOTAL

Revenue
Cash Flow Expenses
M$
M$

Taxes
M$

500
500
400
300
200
100
50

50
50
60
60
70
70
20

225
225
170
120
65
15
15

2,050

380

835

Investment
M$
750

750

Net
Cash Flow
M$
-750
225
225
170
120
65
15
15

Cum
Cash Flow
M$
-750
-525
-300
-130
-10
55
70
85

85

Cumulative Oil Production during 7 years = 200 Mbbl

Cost to Develop Reserves = $750 M/200 Mbbl
= $3.75/bbl

Discount Factors
Convert future values of revenue, expense, or
investment into present values
Used in the calculation of ROR, NPV, and DPI
For annual end-of-year values,

Discount Factor 1 / 1i

Finding Discount Factors

Use ROR or NPV function of calculators
Use published tables

Year, n
1
2
3

Annual
Year End
0.909
0.826
0.751

number of periods

compounding period
I =10%
compounding timing

Continuous, Continuous,
Year End
Mid Year
0.905
0.951
0.819
0.861
0.741
0.779

Rate of Return (ir)

Discounted cash flow rate of return (ROR or ir)
= internal rate of return (IRR)
= nominal discount rate when (present value of
cumulative net cash flow = 0)

j n

j 1

R E I / 1i 0
k

Present value of cumulative net cash

Nominal
flow discount rate

Rate of Return (ir)

number of periods
revenue expenses
investment

j n

j 1

interest or
discount rate

R E I / 1i 0
k

yearly cash flow

varies with time

Start of year = j-1
Mid year = j-0.5
Year end = j

Defining Rate of Return (ir)

Calculation involves iteration (trial
and error) to find the interest rate
that must be used to discount the
cumulative (net) cash flow to zero.

j n

j 1

R E I / 1i 0
k

Net Present Value (NPV)

Net Present Value

cumulative net cash flow at a

specified interest or discount rate

Ppv j 1 R j E j I j / 1i
j n

companys cost of capital

or borrowing rate
(typically 10%;
higher if interest rates are high]

Net Present Value (NPV)

Net Present Value

If NPV >0,
project
=
< 0,then
then
project
is
adds
to the
companys
investment
generally
considered
simply
value.
returns
uneconomic.
cost of borrowing.

Ppv j 1 R j E j I j / 1i
j n

Profit-to-Investment Ratio
Discounted Profit-to-Investment Ratio
(Discounted Profitability Index)

Ppv I pv
DPI ( Ppv / I pv )
11
I
pv

I / 1i

Present value of investments

j n

I pv

j 1

Cost of capital
(borrowing rate)

Discounts
Hurdle rate (minimum DPI)
depends on economic environment

DPI ( Ppv / I pv ) 1
Typical profitability ratio

Estimating Profitability

DPI ( Ppv / I pv ) 1
j n

j 1

Profitability will be low.

R E I / 1i 0
Profitability will be high.

Exercise 1
Name and describe the major
economic yardsticks.

Exercise 2
An exploration project requires drilling a discovery
well in the first year and two development wells in
the second year. The revenues, expenses, and
investment costs are summarized below.
Year
1
2
3
4
Totals

Revenue
800,000
2,000,000
1,500,000
500,000
4,800,000

Expense
400,000
1,300,000
800,000
510,000
3,010,000

Investment (Net) Cash Flow

500,000
-100,000
1,200,000
-500,000
0
+700,000
0
-10,000
1,700,000
+90,000

Units may be dollars, yen, sterling, pesos, or any convenient currency.

Calculate ROR, NPV, DPI, and payout time.

Use an interest rate of 10% and mid-year discounting.

Do you believe this project is a good investment?

Summary
Time value of money is important in
estimating profitability.
Profit, payout, and cost to find and
develop reserves are affected by the
time value of money.
ROR, NPV, and DPI are independent of
the time value of money.