Page 4: Investment appraisal
Discounted cash flowis an important technique for investment appraisal. The discounted cash flow approach is a way of valuing the future returns on investment by assessing the values of these returns in terms of their value today. It places emphasis on the cost of funds tied up in a project by considering the timing of cash flows.
For example, we all instinctively know that £1 in the hand today is worth more than a promise of £1 in the future. This is because:
- Inflation may lower the real value of money.
- The money cannot be put to constructive use in the meantime (i.e. earning interest in the bank or applied to another project).
- There is always the risk that unforeseen circumstances will prevent you receiving the amount you have been promised.
Appraising investments using the discounted cashflow method allows the Company to undertake a capital allocation process, which involves ranking projects and selecting those that add the most value to the Company. It therefore incurs the opportunity cost of those projects that add value but cannot be financed as sufficient funds are not available to undertake them.
Ultimately, the value of any investment is the present value of the future free cash flows - Net Present Value (NPV)- that the investment is expected to generate. Therefore, it is necessary to forecast the economic cashflows and discount them appropriately to allow for the fact that they will not be received until some time in the future. BG Group uses a discount rate that reflects the return its investors (shareholders and banks) expect for investing in a non risk free activity (compared to depositing money in a bank account).
The NPV calculation always assumes the project is a success. However, there is a chance that no oil or gas is present (geological risk), this risk must therefore be reflected in the valuation. This is achieved by assigning probabilities to the values of successful and unsuccessful outcomes. The sum of these risked values is the Expected Monetary Value (EMV).
The EMV calculation can be illustrated by a decision tree. Decision trees are a simple way of choosing from alternative courses of action when faced with uncertainty. The basic procedure for constructing a decision tree is to set out a series of alternative branches of the tree and then to calculate the probability of the event occurring and the likely money value of the return.
In a decision tree, it is possible to distinguish between points of decision and points where chance and probability (uncertainty) may come into play. For example, this process can be used to illustrate possible returns from drilling a well and then exploiting a gas field.
The diagram shows how inputs from geologists,engineers and others underpin the economic analysis and ultimately the calculation of value. These inputs relate to both internal and external data:
- Internal - technical data - relating to the costs involved in developing the block, e.g. the costs of building and developing the gas platforms, likely volume and quality of hydrocarbons.
- External - commercial data - about the future demand for, and price of, gas as well as likely tax changes, and information about local markets and other data.
Economists can then develop models projecting the likely costs and revenuesof developing new fields.
Essential components of these models are:
- revenues (price x volume)
- government take (e.g. taxes because the blocks that companies bid for are government property).Revenues less costs, less government take = the net cashflows which are discounted to give the NPV.
BG Group then uses all of this information to calculate the EMV of decisions. The EMV is equal to:
EMV = (NPV of success x chance of success) plus (NPV of failure x chance of failure)
The following example uses estimated returns expected from BG Group committing itself to drilling one exploration well. The net present cost will be £16m. There is a 16% chance that the three year project will be a success, yielding a return at NPV of £114m.
- First of all we work forward across the diagram from the decision fork where the choice is: 'drill exploration well' or 'don't drill exploration well'.
- Next, we set out the probabilities of gas being discovered and the NPV of success or failure (these are based on the geologists' and economists' calculations).
- If the well is not drilled there will be a return of £0. If the exploration well is drilled and no gas is found there will be a loss of £16m. There is an 84% chance of this being the case.
- If the exploration well is drilled and gas is found there will be a gain of £114m. There is a 16% chance of this happening.
We can now work out the EMV if the decision is made to go ahead with exploiting the field.
Therefore, on a risked basis drilling the well is attractive on economic grounds in that it generates a positive EMV. The opportunity would be presented to management to compete for funds in the capital allocation process.