K Faid - Master PDVSA - Module 12 - 2009

IFP Training course for PDVSA
MSc in refining engineering and gas
Module 12
Investment Profitability
Investment Profitability Studies
Studies
in the
in the Petroleum
Petroleum Industry
Industry
Karim Faïd
Contents
Contents
Introduction
Introduction

Fundamentals of
Fundamentals of general
general methodology
methodology 33
Value creation
Value
creation and
and profitability
profitability analysis
analysis 16
16
Principles of
Principles
of risk
risk analysis
analysis methodology
methodology 68
68
Conclusion
Conclusion

From projects’
From projects’ value
value to
to corporate
corporate financial
financial performance
performance 84
84
Value creation and performance
StrategicManagement
Strategic Managementaimsaimsat
atValue
ValueCreation
Creation
ititis
isaasystem
systemfor
forallocating
allocatingresources whichallows
resourceswhich allows
thecompany
the companyto
toimprove
improveperformance.
performance.
Value
Value
Valueisiscreated
¾¾Value createdthrough
throughinvestment
investmentprojects.
projects.
Profitability studies
¾¾Profitability studies allow
allow one
one to
to evaluate
evaluate the
the value
value that
that could
could be
be
createdby
created byananinvestment
investmentproject.
project.
Performance
Performance
Analysts and
¾¾Analysts and shareholders
shareholders want
want to
to compare
compare companies,
companies, follow
follow their
their
evolutionand
evolution andanticipate
anticipatetheir
theirfuture
futureperformance.
performance.
© 2009 IFP Training

Tools for
¾¾Tools for measuring
measuring performance
performance are
are the
the financial
financial statements
statements and
and
thefinancial
the financialratios.
ratios.
3
Economic evaluations as a communication tool

Corporate Success
based on
the correct evaluation of investment opportunities and the results of decisions
Economic Evaluations
the communication tool
TECHNICAL
TECHNICAL MANAGEMENT
MANAGEMENT
STAFF
STAFF
Most of the investment decisions are based on the overall financial impact
of an investment opportunity rather than on specific technical considerations.
Exchange
of sufficient and appropriate
Evaluating information / data Recommending
the data a course of action
Making the Final Decision

Total awareness increases the quality of decision-making process
4
Profit planning
Long-Term Planning provides Objectives and Goals beyond the short-term
Consciousness of Future Expected Events
Today’s Actions
Therefore, management concentrates on those events

that can produce
the best and largest economic results.
5
Risk dynamics of the petroleum industry
6
Decision process
Studies
Studies PROJECT
PROJECT Operations
Operations
Preliminary
Preliminary Basic
Basic
Studies Engineering Start-Up
Start-Up
Studies Engineering
Conceptual
Conceptual
Studies
Studies
Detailed Field
Field
Pre-Project Detailed
Pre-Project Engineering Operations
Operations
Engineering
GO
GO/ /NOT
NOTGOGO Contractor
Contractor Provisional
for Advanced
for Advanced Provisional
Selection
Selection Acceptance
Studies
Studies Acceptance
GO
GO/ /NOT
NOTGO
GO
To Launch
To Launch
Pre-Project
Pre-Project Final
Final
GO End
Endof
GO/ /NOT
NOTGO GO of Acceptance

To Start Construction Acceptance
To Start Construction and
and and
Project
Project andTests
Tests Production
Production
Project sanction and phasing
Project
Project Sanction
Sanction

AA long
long and
and complex
complex process
process requiring
requiring operator,
operator, partners
partners and
and authorities
authorities approval.
approval.

Economic
Economic studies
studies with
with risk
risk evaluation
evaluation and
and sensitivity
sensitivity analysis
analysis have
have to
to be
be provided
provided as
as part
part of
of the
the
recommendation
recommendation to to approve
approve the
the Project.
Project.

The
The sanction
sanction may
may take
take place
place before
before or
or after
after the
the Basic
Basic Engineering
Engineering phase
phase depending
depending on
on the
the type
type of
of
project.
project.
Feasibility and,
Pre-Project Studies Contracts
Awards Transfer
Start-up
Detailed Studies
Contracts Negotiations
Manufacturing
and Construction
Exploitation Phase
Basic Engineering Phase

Construction & Commissioning Phase

8
Cost estimation methods

9
Cost estimate structure
Equipment
9MainEquipment
9Main
9Bulk
9Bulk DirectCosts
Direct Costs
9Construction
9Construction Technical Costs
+
9Transportation
9Transportation
9Temporary Facilities
9TemporaryFacilities IndirectCosts
Indirect Costs
Camps
9ConstructionCamps
9Construction
+
Services
9EngineeringServices
9Engineering
9Management&&Supervision
9Management Supervision GeneralExpenses
General Expenses
9Surveys
9Surveys
+
9Insurance
9Insurance AssociatedExpenses
Associated Expenses
9Commissioning
9Commissioning
+
FacilitiesCost
Facilities CostEstimate
Estimate = Contingencies
Contingencies
10
The investment project’s magic triangle
AAproject
projectisisaaglobal
globalapproach
approachto
toachieve
achieveaadefined
definedobjective
objective
AAproject
projectisisaamethod
methodand
andaatool
tooldesigned
designedtotocontrol
controlan
anindustrial
industrialinvestment
investment
AAproject
projectis
isbased
basedupon
uponan
aneconomic
economicreality
reality
Schedule Cost
Schedule means VALUE Cost means
Forecast and Anticipation CREATION Budget Control and Forecast
Quality
Quality also means Safety

The project team has to manage all three aspects
11
Economic evaluation of a project

What does an economist need
to model and evaluate the economics of a project?
Technical Data
¾ Capital Expenditures (tangible, intangible, schedule, currencies)
¾ Operating Expenses (fixed, variable, schedule, currencies)
¾ Abandonment or Decommissioning Cost (schedule, currencies)
¾ Production Profile (annual volumes or quantities)
Economic Assumptions and Fiscal Framework

¾ Products Prices
¾ Pipeline Tariffs
¾ Inflation Rate, Escalation Factors, Exchange Rates
¾ Fiscal Terms (duties, taxes, provisions, depreciation, …)
Discount Rate
Fixed by the Management and linked to:

¾ Company’s Cost of Capital Employed, and
¾ Management’s Appreciation of Risk
12
Decision based on cash flow modeling and analysis
PROJECT
PROJECT Operating Revenues
Capital Expenditures Operating Expenses
Gvt Take
ECONOMICINDICATORS
ECONOMIC INDICATORS
NetPresent
Net PresentValue
Value
InternalRate
Internal Rateof
ofReturn
Return
Pay-OutTime
Pay-Out Time
FinancialExposure
Financial Exposure
Profitability Index
Profitability Index
EconomicCost
Economic Cost
BASICRISK
BASIC RISKANALYSIS
ANALYSIS
SpiderCharts
Spider Chartsor
orTornado
TornadoDiagrams
Diagrams

Sensitivityanalysis
Sensitivity analysisofofmain
maineconomic
economicindicators
indicators
toimportant
to importantrisk
riskfactors:
factors:price,
price,production,
production,capex,
capex,opex.
opex.
13
Dependent projects
CommonResource
Common Resource
Project A Project B
Competition
or
Complementarity
Dependence of Receipts and Expenses of Projects A and B
Competing
Value(A+B)
Value(A+B) << Value(A)
Value(A) ++ Value(B)
Value(B)
Projects
Complementary
Value(A+B)
Value(A+B) >> Value(A)
Value(A) ++ Value(B)
Value(B)
Projects
14
InvestmentProfitability
Investment ProfitabilityStudies
Studies
inthe
in thePetroleum
PetroleumIndustry
Industry
Contents
Contents
Introduction
Introduction

Fundamentals of
general methodology
methodology 33
Value creation
Value
creation and
and profitability
analysis 16
16
Principles of
Principles
of risk
risk analysis
methodology 68
68
Conclusion
Conclusion

From projects’
value to
to corporate
corporate financial
performance 84
84
Corporate finance and capital employed
Equity Capital Debt Capital
Capital
Employed
Shareholders Lenders
Capital Employed
is to be remunerated from the return on investment projects
aa project
project will
will be
be financed
financed by
by aa fraction
fraction of
of the
the total
total capital
capital available.
available.
16
Cost of capital and value creation in the absence of risk
All
All funds
funds make
make up
up total
total capital
capital employed
employed to
to which
which one
one must
must associate
associate aa single
single cost
cost
WEIGHTED
WEIGHTED AVERAGE
AVERAGE COST
COST OF
OF CAPITAL
CAPITAL
CONDITION FOR VALUE CREATION IN THE ABSENCE OF RISK
Investment projects must provide Project’s Rate of Return (%)

an economic profitability
higher than Project’s

Value
the company’s average cost of capital Company’s Cost of Capital (%)

Otherwise, the project would destroy value for the company.
17
Corporate finance and weighted average cost of capital
α Company’s debt ratio (Debt Capital / Total Capital)
WeightedAverage
Weighted AverageCost
Costof
ofCapital
Capital
ii==ααee++(1
(1––αα))CCp
p
(1-α)% α%
Cost Cp Cost e
Remuneration Remuneration
Total Capital
expected by contracted with
shareholders lenders
Example
α= 25% Debt 1–α = 75% Equity
cost e = 4% cost Cp = 12%
WACC = i = 0.25*4% + 0.75*12% = 10%
18
Cost of debt capital
• The cost of debt capital corresponds to the market interest rate, plus a premium
for the lender. The premium depends on the quality of the company, on the
guaranties of the parent-company when the borrower is an affiliate, and on the
country risk.
• Notation of companies
– The notation is the evaluation by a specialized independent agency of the
risk of non-payment of loans.
– This notation condition the access to loans from financial markets and
bankers: amount of further loans, interest rates charged…
• A number of ratios are computed by financial analysts and if those ratios are
beyond some given limits, the lenders will be very reluctant to agree to further
loans:
• Gearing = Debt Capital / Equity Capital

• Cover Ratio = Operating Income / Financial Charges
19
Cost of equity capital
• The cost of equity capital for the company is the rate of return expected by the
shareholders.
• The shareholders anticipate some remuneration which depends on future

dividends and capital gains.
• A number of models of financial theory attempt to address this difficult

question of the determination of the cost of equity capital.
• Because of the higher risk faced by shareholders, their remuneration needs to

be higher than that of bankers; and, therefore, from the point of view of the
firm:
Cost of Equity Capital > Cost of Debt Capital
20
Cost of equity capital / Gordon Shapiro model
• Assumptions of Gordon Shapiro model

– the shareholder holds the stock for an infinite period.
– the dividend grows in each period at a constant rate, starting from a given
initial dividend.
• With a rate of return demanded by shareholders, the stock value must be

equal to the present value of the sum of dividends.
• Cost of equity capital

= rate of return expected for equity capital = Cp = D0 / V0 + g
with D0 dividend, V0 stock value, g dividend’s growth rate.
Example : D0 = 14, V0 = 100, g = 1%, then Cp = 15%

21
Cost of equity capital / capital asset pricing model
• Assumptions of the capital asset pricing model

– there is a risk-free asset, with thus a guaranteed return.
– the specific risk of an asset can be eliminated through diversification.
– The non-specific or systematic risk must be remunerated.
• The rate of return demanded by shareholders must be equal to the risk-free

rate plus a risk premium to remunerate the non-specific risk.
• Cost of equity capital

= rate of return expected for equity capital = Cp = Rf + β . [E(RM) – Rf]
Rf risk-free interest rate

E(RM) expected market yield
[E(RM) – Rf] market risk premium
β[E(RM) – Rf] risk premium of the asset
β asset risk factor relative to market = Cov (R; RM) / Var (Rm) with R = asset’s yield
Example : Rf = 6%, E(RM )= 11%, β = 1.8 then Cp = 15%

22
Cost of capital and level of debt ratio
Cost
Cost of Capital
Cost
EquityCapital
Equity Capital WeightedAverage
Weighted AverageCost
Costof
ofCapital
Capital
Cost
Cost
Debt Capital
Debt Capital
Debt Ratio

In practice, it is often very difficult to determine precisely the average cost of capital.
23
Cash flows of an investment project

(Operating Period = N years)
PROJECT
PROJECT Revenues
Capex Opex
Gvt Take
Cash
Cash Flow
Flow == Cash
Cash Inflow
Inflow –– Cash
Cash Outflow
Outflow
Operating period
Present
years
Investment
It is not valid to compare funds received or spent at different periods.

One must “bring” all cash flows from the future to the present,
that is
discount all the project’s cash flows.
24
Time value of money and discount rate
FutureValue
Future Valuein
inyear
yearnnof
ofaaPresent
PresentCash
CashFlow
FlowCF
CF0
0
compounding
CF0 CFn = CF0 . (1+i)n
Amount that can be obtained in year n from saving

every year, with an annual interest i, the present cash flow CF0
PresentValue
Present Valueof
ofaaFuture
FutureCash
CashFlow
FlowCF
CFnfrom
fromyear
yearnn
n
CFn discounting
CF0 = CFn
(1+i)n
Amount that can be borrowed today and paid back,
with an annual interest i, in n years with the future cash flow CFn

Inthe
In theabsence
absenceof
ofrisk,
risk,Time
TimeValue
Valueof
ofMoney
Moneyisismeasured
measuredby
by
Discount Rate = Cost of Capital
Discount Rate = Cost of Capital
25
Asset value is the present value of future net cash flows
FutureNet
Future NetCash
CashFlows
Flows
i = 10%
Year 0 1 2 3 4 5 6 Sum
0 20 30 50 50 50 50 250
Acc.
18 18
43 25
@10%»»
81 38
Value@10%
115 34
PresentValue
146 31
««Present
174 28
DiscountedCash
Discounted CashFlows
Flows
26
Concept of net present value
FutureNet
Future NetCash
CashFlows
Flows
i = 10%
Year 0 1 2 3 4 5 6 Sum
-100 20 30 50 50 50 50 150
Loan»»
««Loan
Acc.
18
««Net
-82
NetPresent
-57 25
PresentValue
@10%»»
Value@10%
-19 38
Value@0%
PresentValue
15 34
@0%»»
NetPresent
46 31
74 28
««Net

DiscountedCash
Discounted CashFlows
Flows
27
Corporate finance and discount rate of a company
Financing
Financing Decision
Decision Investment
Investment Decision
Decision
(selecting
(selecting financial
financial sources)
sources) (selecting
(selecting investment
investment projects)
projects)
Debt Capital Operational Division

Cost e i PROJECT
PROJECT
Finance Division Capex
in charge of
Revenues
Corporate Finance Policy
Cost Cp Opex
Equity Capital Gvt Take
FinancialTheory
Financial Theoryexcludes
excludesRiskRisk
Company’sDiscount
Company’s DiscountRate
Rate==Weighted
WeightedAverage
AverageCost
Costof
ofCapital
Capital
i i==ααee++(1
(1––αα) )CCp
p

Forthe
For themanagement
managementof
ofthe
thecompany
companyfacing
facingtechnical,
technical,economic,
economic,and
andcontractual
contractualrisks,
risks,
Company’sDiscount
Rate==Weighted
WeightedAverage
AverageCost
CostofofCapital
Capital++Risk
RiskPremium
Premium
28
Discount rate and value creation in the presence of risk
CONDITION FOR VALUE CREATION IN THE PRESENCE OF RISK
Investment projects must provide

an economic profitability
Project’s Rate of Return (%) IRR
higher than
Project’s
the company’s discount rate Value
RiskPremium
Premium
Company’s Discount Rate (%) ii
Risk
introduced by
introduced by thethemanagement
management
to mitigate the overall risk
to mitigate the overall risk
Company’s Cost of Capital (%)

AAcompany
companypresent
presentin
inseveral
severalsectors
sectorsand/or
and/orseveral
severalcountries
countrieswith
withvarying
varyinglevels
levelsof
ofrisk
risk
mustthen
must thenuse
useseveral
severaldiscount
discountrates
ratesincorporating
incorporatingits
itsown
ownperception
perceptionof
ofrisk.
risk.
29
Discount Rate = WACC / Conditions
Condition11
Condition
Thesize
The sizeof
ofthe
theproject
projectdoes
doesnot
notchange
changesignificantly
significantly
thefinancial
the financialstructure
structureof
ofthe
thefirm.
firm.
Therelative
The
relativeweight
weightof
ofthe
thefirm’s
firm’svarious
varioussources
sourcesof
offinancing
financingshould
shouldnot
not
bemodified.
be modified.
IfIfthat
thatis
isnot
notthe
thecase,
case,the
theaverage
averagecost
costof
ofcapital
capitalis
isdetermined
determinedfrom
fromthe
the
newfinancial
new financialstructure
structurewhich
whichincorporates
incorporatesthe
thefinancing
financingofofthe
theproject.
project.
Condition22
Condition
Thereis
There isno
nocapital
capitalrationing.
rationing.
Atthe
At
thelimit
limitofofthe
thebudget
budgetconstraint,
constraint,each
eachselected
selectedproject
projectlimits
limitsfurther
further
accessto
access toloans.
loans.
Thiswould
This
wouldthen
thenchange
changethe
theaverage
averagecost
costof
ofcapital.
capital.
30
Nominal money and constant money : «inflate» / «deflate»
Money of the Day with an Inflation Rate d
1$0 1$1 1$2 ……. 1$n
1$0 = * (1+d)
n
1$n Monetary depreciation is summarized
in the annual inflation rate
1$n = 1$0 / (1+d)n measured by the Consumer Price Index
Cash Flow of Year n

Constant
Constant Money
Money
CFn($0)
“Inflate”
* (1+d)
n
/ (1+d)n “Deflate”

CF’n($n)
Nominal
Nominal Money
Money
31
Price evolution in nominal money and constant money
Inflation = d = 5% a year
Priceof
Price ofaaSpecific
Specific
Goodor
Good orService
Service
Nominal Money
P’
Nominal Money Basket
δ’ = +7% a year P
Constant Money
δ = +1.9% a year
Constant Money
years
1+δδ’’==(1+
1+ (1+δδ))..(1+d)
(1+d)
δδ’’≈≈δδ++dd
32
Interest rates in nominal money and constant money
Without Inflation
Lenders
Lenders
Sn = S0 * (1+e)n
S0 Sn
eeinterest
interestrate
rate
Loan (in real terms)
Payoff
With Inflation
Lenders
Lenders
S’n = S0 * (1+e’)n = Sn * (1+d)n
S0 e’interest
interestrate
rate S’n
e’ Payoff
Loan

(in nominal terms)
(1+e’)==(1+e)
(1+e’) (1+e) *(1+d)
(1+d)
*
e’≈≈ee++dd
e’
33
Discount rates in nominal money and constant money
Making the Final Decision
NominalMoney
Money OR Constant
ConstantMoney
Money
Nominal
Project’s Rate of Return (%) IRR’

IRR’ IRR Project’s Rate of Return (%)
Project’s
Value
Company’s Discount Rate (%) i’

i’ i Company’s Discount Rate (%)
Company’s Cost of Capital (%) Company’s Cost of Capital (%)

1+i’==(1+i)
1+i’ (1+i) *(1+d)
(1+d)
*
i’i’≈≈ii++dd
34
Discounting in nominal or constant money
PresentValue
Present Valueof
ofaaFuture
FutureCash
CashFlow
FlowCF’
CF’nfrom
fromyear
yearnn
n
With Inflation
CF’n discounting
CF0 = CF’n
(1+i’)n
CFn = CF’n / (1+d)n

with an annual interest rate i’, in n years with the future cash flow CF’n
PresentValue
Present Valueof
ofaaFuture
FutureCash
CashFlow
FlowCF
CFnfrom
fromyear
yearnn
Without Inflation
CFn discounting
CF0 = CFn
(1+i)n
with an annual interest rate i, in n years with the future cash flow CFn

Discounting in nominal or constant money:
1+i’ = (1+i) * (1+d) One, and only one Present Value
35
Project’s cash flows analysis

(Operating Period = N years)
PROJECT
PROJECT Revenues
Capex Opex
Gvt Take
Company’s Cash Flows Schedule
Year 0 … to ... N
Revenues (1)
Capex (2)
Opex (3)
Gvt Take (4)

Company’s Cash Flows CF = (1-2-3-4)
36
Economic indicators of profitability studies
ECONOMICINDICATORS
ECONOMIC INDICATORS
NetPresent
Net PresentValue
Value
InternalRate
Internal Rateof
ofReturn
Return
Pay-OutTime
Pay-Out Time
FinancialExposure
Financial Exposure
ProfitabilityIndex
Profitability Index
EconomicCost
Economic Cost

37
Economic criteria / Net Present Value
NetPresent
Net PresentValue
Valueof
ofaaCash
CashFlows
FlowsSchedule
Schedule
Year 0 1 … C … N
n
Discounting at a rate i 1 (1+i) (1+i) (1+i)N
Cash Flows CF0 CF1 … CFn … CFN
Discounted Cash Flows CF0 CF1/(1+i) … CFn/(1+i)n … CFN/(1+i)N
Net Present Value = Sum of Discounted Cash Flows
N
CFn
NPV = ∑
n = 0 (1 + i )
n
i = Discount Rate
38
Economic criteria / Net Present Value
N
CFn
NPV = ∑
n = 0 (1 + i )
n
IfIfNPV
NPV==00
Therevenues
The revenuesof ofthe
theproject
projectarearesufficient
sufficientto:
to:
payall
¾¾pay alltypes
typesofofexpenses
expenses
repaythe
¾¾repay thecapital
capitalinvested
invested
remunerateititat
¾¾remunerate ataarate
ratejust
justequal
equaltotothe
thediscount
discountrate
rate
The
The value
value of
of the
the discount
discount rate
rate which
which takes
takes NPV
NPV to
to zero
zero
measures
measures the
the rate
rate of
of return
return from
from the
the investment
investment project
project

39
Economic criteria / Internal Rate of Return
NPV
IRR
Discount Rate
Company’s
Discount Rate
Project’s
Project’s IRR
IRR == Return
Return on
on Capital
Capital Invested
Invested
Value
Value Creation
Creation if
if and
and only
only if
if NPV
NPV >> 00
Internal
Internal Rate
Rate of
of Return
Return >> Discount
Discount Rate
Rate
40
Computing NPV and the IRRs
Discount
Discount Rate
Rate i’i’ Discount
Discount Rate
Rate ii
Nominal
Nominal Money
Money Constant
Constant Money
Money
Cash
Cash Flow
Flow CF'
CF'nn Cash
Cash Flow
Flow CF
CFnn
Nominal
Nominal Money
Money
NPV
NPV Constant
Constant Money
Money
CF ' n CFn
NPV = ∑ NPV = ∑
(1 + i ' ) n (1 + i ) n
CF ' n = CF n (1 + d ) n
n n
1+i' = (1+i) ** (1+d)

(1+d)
i'i' ≈ ii ++ d
d
Rate
Rate of
of Return
Return IRR'
IRR' Rate
Rate of
of Return
Return IRR
IRR

Nominal
Nominal Money
Money Constant
Constant Money
Money
1+IRR'
1+IRR' = (1+IRR) ** (1+d)
(1+d)
IRR' ≈ IRR
IRR' IRR ++ d
d
41
Economic criteria / comparison of mutually exclusive projects
To compare two mutually exclusive projects

coherently with the principle of maximizing value creation,
one needs to analyze the return on the differential investment.
NPV
IRRA
IRR A
IRRB
IRR B
Discount Rate
(A)
CF0A
(B)
CF0B
IncrementalRate
Incremental Rateof
ofReturn
Return
Differential Project (B/A) is described by the Differential Cash Flows

Incremental rate of return = Discount rate for which NPV(B/A) = NPV(B) − NPV(A) = 0
42
Economic criteria / Pay-Out Time - Financial Exposure
Pay-Out Time definition:

Operating period necessary for
the cash flows from the project to reimburse the capital invested.
NPV
NPV
POT
M$
0 1 2 3 4 5 6 7 8 9 10 11 12
Financial
Financial
Exposure
Exposure
Cash Flows Acc. Cash Flows

43
Economic criteria / Pay-Out Time and Financial Exposure
Single independent project
¾ Set a ceiling for financial exposure criterion
¾ High risk investments:
Define empirically a maximum pay-out time of reference depending on:

. estimated lifetime of the equipment
. uncertainties about future revenues
. company’s objectives
Reject projects with a POT greater than this value
Choosing between projects

Projects with similar NPV:

choose the project with shortest POT
44
Economic criteria / Profitability Index
PI NPV PI NPV
PI = PI =
Investment Financial Exposure
PROFITABILITYINDEX
PROFITABILITY INDEX
AAMEASURE
MEASUREOF
OFVALUE
VALUECREATED
CREATEDPERPERDOLLAR
DOLLARINVESTED
INVESTED

At the margin, a unit of capital needs to be directed to the project which creates most value.
45
Capital rationing
To select between various investment projects with the constraint of a limited budget,
there are two simple methods:
Profitability
Profitabilityindex
indexmethod
method
Choosing
ChoosingIndependent
IndependentProjects:
Projects:Projects,
Projects,ranked
rankedaccording
accordingtotodecreasing
decreasing
profitability
profitabilityindex,
index,are
arepicked,
picked,one
oneafter
afterthe
theother,
other,up
upto
tothe
thepoint
pointwhere
where
««Total
TotalCAPEX
CAPEX==Capital
CapitalAvailable
Available»»
Scarcity
Scarcitycost
costofofcapital
capital
Choosing
ChoosingIndependent
IndependentProjects:
Projects:Projects,
Projects,ranked
rankedaccording
accordingtotodecreasing
decreasing
internal
internalrate
rateof
ofreturn,
return,are
arepicked,
picked,one
oneafter
afterthe
theother,
other,up
upto
tothe
thepoint
pointwhere
where
««Total
TotalCAPEX
CAPEX==Capital
CapitalAvailable
Available»»
46
Economic criteria / Unit Economic Cost
Break-EvenPrice
Break-Even Price
UnitSelling
Unit SellingPrice
Pricesuch
suchthat
thatNPV
NPV==00
NoProfit,
No Profit,No
NoLoss
Loss
Break-EvenPrice
Break-Even Price==Unit
UnitEconomic
EconomicCost
Cost
Unit Selling Price ($/t)
Project’s
Value
Unit Economic Cost ($/t)
NPV>>00ififand
NPV andonly
onlyifif

UnitSelling
Unit SellingPrice
Price>>Project’s
Project’sUnit
UnitEconomic
EconomicCost
Cost
47
Economic criteria / Annual Economic Cost
Break-EvenAnnual
Break-Even AnnualRevenues
Revenues
AnnualRevenues
Annual Revenuessuch
suchthat
thatNPV
NPV==00
NoProfit,
No Profit,No
NoLoss
Loss
Break-EvenAnnual
Break-Even AnnualRevenues
Revenues==Annual
AnnualEconomic
EconomicCost
Cost
Annual Revenues (M$)
Project’s
Value
Annual Economic Cost (M$)
NPV>>00ififand
NPV andonly
onlyifif
AnnualRevenues
Annual Revenues>>Project’s
Project’sAnnual
AnnualEconomic
EconomicCost
Cost
48
Costs vs profits
Reasons for analyzing costs for an investment project:
– uncertainty over selling prices higher than the uncertainty related to

costs: find the minimum selling price for the viability of the
investment.
– a production or a service may have to be charged at “cost”.
– market for a firm's product is given or a fixed objective for strategic
reasons: choose the project that meets the demand at the minimum
cost.
– choice between alternative solutions providing the same services:
criterion of minimum discounted cost
leads to the same decision as
criterion of maximum net present value.
Project's Discounted Cost

= Total Discounted Cost (Investment + Operating Expenses)
49
Global profitability analysis / Summary
PROJECT
PROJECT Revenues
Capex Opex
Gvt Take
i i i==ααee++(1
(1––αα) )CCp
p
Equity
Equity Capital
Capital e
StandardFinancial
Standard FinancialStructure
Structure
of company’s portfolio Finance
of company’s portfolio
ratioα,α,cost
(debtratio costofofdebt
debte)e)
Finance Division
Division OperationalDivision
Division
(debt Operational
Debt
Debt Capital
Capital Cp
FinancialTheory
excludesRisk
Risk
Company’sDiscount
Rate==i i==Weighted
WeightedAverage
AverageCost
Costof
ofCapital
Capital
independent of any fiscal regime
independent of any fiscal regime
Practical
Practical experience
experience incorporating
incorporating management’s
management’s assessment
assessment of of risk:
risk:
Discount
Discount Rate
Rate == Weighted
Weighted Average
Average Cost
Cost of
of Capital
Capital ++ Risk
Risk Premium
Premium
50
Global profitability analysis / Summary
Technical
Technical Data
Data in
in Constant
Constant Money
Money Economic
Economic Assumptions
Assumptions & & Fiscal
Fiscal Regime
Regime
Capex,
Capex, Opex, Production profile
Opex, Production Price,
Price, Inflation d, Discount rate
Inflation d, Discount rate ii
Inflate
profile
x(1+d)n Fiscal
Fiscal Terms
Terms
Company’s
Company’s Cash
Cash Flows
Flows Schedule
Schedule
Year 0 … to ... N
Revenues (1)
Duties (2)
Capex (3) Project’s
Project’s
Fiscal Depreciation (4) Economic Indicators
Economic Indicators
Opex (5) N
CFn
NPV = ∑
Others (6) n =0 (1 + i )
n
(interests, carry, provisions, etc.)
Corporate Taxable Income (7) = (1-2-4-5-6) IRR = i

Corporate Income Tax (8) = (7) x tax rate such that NPV = 0
Gvt Take (9) = (2+8)

Company’s Cash Flows CF’ = (1-2-3-5-8)
Deflate
Cash Flows Constant Money CFn = CF’n / (1+d)n

51
Basic fiscal rules
Fiscal Depreciation
3spreads the investment cost over the depreciation period.
3rules are set in the petroleum contract, depending on type of investment.
3depreciation is generally charged starting the first year of exploitation.
3 Σ depreciation charges = nominal value of asset, except when there is an uplift.
3straight-line depreciation: constant depreciation charges = Capex / Nbre years
Consolidation
3a negative taxable income of a project is consolidated at the level of the
company’s result in the country. Provided the latter is positive, this will induce
tax savings (or tax shield) which must be credited to the project.
Ringfencing
3a negative taxable income of a project is a fiscal loss which is carried forward
to the following fiscal year. It is then a charge which can de deduced in the
computation of the taxable income.
52
Consolidation and Ringfencing
CONSOLIDATION Year 0 1 2 3 4 5
Revenues (1) 40 70 70 70 70
Capex (2) 140
Depreciation (3) 35 35 35 35
Opex (4) 20 25 25 25 25
Income (5)=(1-3-4) -15 10 10 10 45
Tax (6)=(5) * t -6 4 4 4 18
Cash Flows (7)=(1-2-4-6) -140 26 41 41 41 27
Year 0 1 2 3 4 5
RINGFENCING (1)
Revenues 40 70 70 70 70
Capex (2) 140
Depreciation (3) 35 35 35 35
Opex (4) 20 25 25 25 25
Carry Forward (5) -15 -5 0 0

Income (6)=(1-3-4)+(5) -15 -5 5 10 45
Tax (7)=(6)*t if >0 0 0 2 4 18
Cash Flows (8)=(1-2-4-7) -140 20 45 43 41 27
53
Project’s deductible financial charges
AAschedule
scheduleforforaastandard
standardfinancing
financingplan
planisisbuilt
builtin
inorder
orderto
tocompute
compute
thefinancial
the financialcharges
chargesassociated
associatedwith
withthe
theproject,
project,and
anddeduce
deducethem
themin
in
the taxable income if this is allowed for by the fiscal rules
the taxable income if this is allowed for by the fiscal rules of theof the
countrywhere
country wherethetheproject
projectwill
willbe
becarried.
carried.
ConstantAnnuity
Constant Annuity
Year 0 1 2 3 4 5
Loan 100.0
Outstanding Debt (end year) 100.0 83.6 65.6 45.8 24.0 0.0
Capital Repayments 16.4 18.0 19.8 21.8 24.0
Interests 10.0 8.4 6.6 4.6 2.4
Annuities 26.4 26.4 26.4 26.4 26.4
Interest Rate 10%
ConstantCapital
Constant CapitalRepayment
Repayment
Year 0 1 2 3 4 5
Loan 100.0
Interests 10.0 8.0 6.0 4.0 2.0

Annuities 30.0 28.0 26.0 24.0 22.0
Interest Rate 10%
54
Project’s deductible financial charges
AAschedule
scheduleforforaastandard
standardfinancing
financingplan
planisisbuilt
builtin
inorder
orderto
tocompute
compute
thefinancial
the financialcharges
chargesassociated
associatedwith
withthe
theproject,
project,and
anddeduce
deducethem
themin
in
the taxable income if this is allowed for by the fiscal rules
the taxable income if this is allowed for by the fiscal rules of theof the
countrywhere
country wherethetheproject
projectwill
willbe
becarried.
carried.
ConstantAnnuity
Constant Annuity
Year 0 1 2 3 4 5
Loan 100.0
Interests 10.0 8.4 6.6 4.6 2.4
Annuities 26.4 26.4 26.4 26.4 26.4
Interest Rate 10%
Year 0 1 2 3 4 5 6
Loan 60.0 40.0
Outstanding Debt (end year) 60.0 106.0 88.6 69.5 48.5 25.4 0.0
Capitalized Interests 6.0

Interests 10.6 8.9 7.0 4.9 2.5
Annuities 28.0 28.0 28.0 28.0 28.0
Interest Rate 10%
55
Classical global profitability analysis:

a simple, particular case of one simple fiscal regime
ALL
ALL PROJECTS
PROJECTS Revenues
IN
IN ONE
ONE COUNTRY
COUNTRY
Capex Opex
ONE
ONE FISCAL
FISCAL REGIME
REGIME
BASED
BASED ON
ON
A
Tax
A CORPORATE
CORPORATE INCOME
INCOME TAX
TAX
i i i==αα(1-t) (1––αα) )CCp

(1-t)ee++(1
p
Equity
Equity Capital
Capital e
StandardFinancial
Standard FinancialStructure
Structure
of company’s portfolio Finance
of company’s portfolio
ratioα,α,cost
(debtratio costofofdebt
debte)e)
Finance Division
Division OperationalDivision
Division
(debt Operational
Debt
Debt Capital
Capital Cp
FinancialTheory
excludesRisk
Risk
Company’sDiscount
Rate==i i==After-Tax
After-TaxWeighted
WeightedAverage
AverageCost
CostofofCapital
Capital
cansum
can sumupupthe
thedeductibility
deductibilityof
ofthe
thefinancial
financialcharges
chargesat atthe
thecorporate
corporatelevel
levelallowed
allowedby
bythe
the
fiscal regime, and there is no need to compute in the company’s economic
fiscal regime, and there is no need to compute in the company’s economic model model
thefinancial
financialcharges
chargesassociated
associatedwithwitheach
eachinvestment
investmentproject
projectin
inthe
thecountry
country
the
Practical
Practical experience
experience incorporating
incorporating management’s
management’s assessment
assessment ofof risk:
risk:
Discount Rate = After-Tax Weighted Average Cost of Capital + Risk Premium
Discount Rate = After-Tax Weighted Average Cost of Capital + Risk Premium
56
Classical global profitability analysis:
a simple, particular case of one simple fiscal regime
Technical
Technical Data
Data in
in Constant
Constant Money
Money Economic
Fiscal Regime
Regime
Capex,
Capex, Opex,
Opex, Production
Production profile Price,
Price, Inflation d, Discount
Inflation d, Discount rate
rate ii
Inflate
profile
x(1+d)n Corporate
Corporate Income
Income Tax
Tax
Company’s
Company’s Cash
Cash Flows
Flows Schedule
Schedule
Year 0 … to ... N
Revenues (1) Project’s
Project’s
Economic Indicators
Economic Indicators
Capex (2)
Fiscal Depreciation (3) N
CFn
NPV = ∑
n = 0 (1 + i )
n
Opex (4)
Others (5) IRR = i
(carry, provisions, etc.)
such that NPV = 0
Corporate Taxable Income (6) = (1-3-4-5)
Corporate Income Tax (7) = (6) x tax rate
Company’s Cash Flows CF’ = (1-2-4-7)

Deflate

57
After-tax weighted average cost of capital

t Corporate income tax rate
After-TaxWeighted
After-Tax WeightedAverage
AverageCost
Costof
ofCapital
Capital
i’i’==ααê’ê’++(1(1––αα))C’
C’p
p
with ê’
with ê’==(1–t)
(1–t)e’
e’
α%
(1-α)%
Cost Cp ii==ααee++(1(1––αα))CCpp with

with 1+e
1+e==(1+ê’)/(1+d)
(1+ê’)/(1+d)
Cost e
Remuneration Remuneration
expected by contracted with
shareholders lenders
Total Capital
Example
α = 25% Debt 1–α = 75% Equity
cost e’ = 6% cost Cp = 12% inflation rate d = 2% tax rate t = 40%
After-Tax WACC = i = 0.25*1.6% + 0.75*12% = 9.4%

58
Equity capital analysis
Questionin
Question inthe
thefinal
finalphase
phaseof
ofaalarge
largeinvestment
investmentproject
projecteconomic
economicevaluation
evaluation: :
what is the return on equity capital invested in the project with a given financingplan?
what is the return on equity capital invested in the project with a given financing plan?
Dividends Reimbursements
PROJECT
PROJECT
Company Bank

years

Project’s Cash Flows
59
Investment
Project finance
Project finance is the financing of an important project for which the

lender will accept to take into account only
¾ the revenues of the project as means of reimbursement, and
¾ the assets of the project as guarantees for the loans.
In the preparation of the project finance, the banks will have two main
objectives:
¾ determine the viability of the project, and
¾ eliminate as much as possible the specific risks of the project.
The viability of the project finance is determined by the evaluation of

the provisional cash-flows and includes various sensitivity analysis.
60
Advantages of project finance
It preserves the borrowing capability of the sponsor.
It is perfectly adapted to the financing of a large project the

property of which is shared within a joint-venture.
It is suitable for specific needs adapting for example the repayment

of the debt to the build-up of the production of the project.
It reduces the sponsors’ risks strictly to the level of their local

affiliate and allows the participation of companies that have the
technical know-how without necessarily the required financial
capability for a large project.

61
Reminder: global profitability analysis
PROJECT
PROJECT Revenues
Capex Opex
Gvt Take
OperationalDivision
Operational Division
Company’s Cash Flows Schedule
Year 0 … to ... N
Revenues (1)
Capex (2)
Opex (3)
Gvt Take (4)

Company’s Cash Flows CF = (1-2-3-4)

62
Equity profitability analysis / Summary
P
PRRO
O JJ E
ECCT
T Revenues
Bank Loan
Opex
Equity Capital Gvt Take
Repayments
Debt Capital
Interests
Shareholders
Shareholders
Equity Capital
Equity Capital

DiscountRate
Discount Rate==i i==CCp==Cost
Costof
ofEquity
EquityCapital
Capital
p
63
Minimum remuneration expected by shareholders
Equity profitability analysis

Technical
Technical Data
Data in
in Constant
Constant Money
Money Economic
Fiscal Regime
Regime
Capex,
Capex, Opex, Production profile
Opex, Production Price,
Price, Inflation d, Discount rate
Inflation d, Discount rate ii
Inflate
profile
x(1+d)n Fiscal
Fiscal Terms
Terms
Equity
Equity Cash
Cash Flows
Flows Schedule
Schedule 0 … to ... N
Year
Revenues (1)
Operating Cycle
Capex = Equity + Debt (2) EconomicIndicators

Economic Indicators
N
Opex (3) CFn
NPV = ∑
n = 0 (1 + i )
n
Gvt Take (4)
ROE = i
Bank Loan (5)
Financing Plan
such that NPV = 0

Repayments (6)
Interests (7)
Deflate
Equity Cash Flows CF’ = (1-2-3-4+5-6-7)

Internal Rate of Return = Rate of Return on Equity Capital

remuneration of equity capital invested in the project
64
Financial leverage
IRR≈≈(1
IRR (1––αα))ROE
ROE++ααee
A project’s internal rate of return is an overall return on capital invested

which is the weighted average of the return on equity capital and the cost of debt capital
with α being the project’s debt ratio.
Rateof
Rate ofReturn
Returnon
onEquity
EquityCapital
Capital>>Rate
Rateof
ofReturn
Returnon
onCapital
CapitalInvested
Invested
Financial Leverage
Return on equity capital can be raised by increasing the debt ratio.

There is an economic benefit associated with the fact of borrowing part of the capital
since the cost of equity capital is higher than the cost of debt capital.
65
When is an equity capital analysis justified?
Onlyaaglobal
Only globalprofitability
profitabilityanalysis
analysisisiscarried
carriedout
outin
inpreliminary
preliminarystudies
studiestotoevaluate
evaluate
thereal
the realprofitability
profitabilityof
ofthe
theproject,
project,and
anddecide
decidetotocarry
carryon
onor
ornot.
not.
Only
Only aa global
global profitability
analysis is
is justified
justified
ifif the
the company's
company's debt
debt ratio
ratio is
is fixed
fixed for
for the
the whole
whole portfolio
portfolio of
of projects.
projects.
According
According toto the
the principle
principle of
of corporate finance of
corporate finance of non
non allocation
allocation of
of funds
funds toto
uses,
uses, aa project
project will
will be
be financed
financed byby aa fraction
fraction of
of the
the overall
overall capital
capital available
available to
to
which
which is
is associated
associated one
one single
single cost,
cost, the
the average
average cost
cost of
of capital.
capital.
Even
Even for
for aa project
project for
for which
which the
the company
company could
could borrow
borrow more
more than
than for
for the
the
average
average of of its
its portfolio,
portfolio, the
the economic
economic benefit
benefit of
of financial leverage cannot
financial leverage cannot be be
allocated to this project since the
allocated to this project since the debt ratio is imposed upon all projects and
debt ratio is imposed upon all projects and
this
this will
will force
force the
the company
company to to use
use aa smaller
smaller part
part of
of debt
debt in
in the
the other
other projects.
projects.
66
Studies
inthe
in thePetroleum
PetroleumIndustry
Industry
Contents
Contents
Introduction
Introduction

Fundamentals of
general methodology
methodology 33
Value creation
Value
creation and
and profitability
analysis 16
16
Principles of
Principles
of risk
risk analysis
methodology 68
68
Conclusion
Conclusion

From projects’
value to
to corporate
corporate financial
performance 84
84
Reasons of failure
There are many reasons

why projects fail to meet forecast results:
Technical reasons
Overly optimistic expectations
Delay in completion
Management problems
Cost overruns
Price volatility
Financial failure of involved parties
68
What is risk analysis?
The risk in the petroleum industry is in general subjective: estimating the

probabilities associated with potential results demands often intuition with
subjective and personal judgments.
In spite of being subjective, risk can be analyzed quantitatively. Such analysis

is useful because:
¾ it forces the analyst to make a more objective evaluation of the factors

affecting the data.
¾ it forces assumptions to be reviewed and justified.
¾ complex decisions with many alternatives can be investigated.
¾ assessing risk and uncertainty in probabilistic terms is a clear and

concise way to convey results to management.

¾ it provides a consistent method to compare investments in different areas
and with differing levels of uncertainty.
69
Basic risk analysis in investment profitability studies
Taking risk into account

¾ discount rate with a risk premium
¾ pay-out time criterion
¾ sensitivity analysis
Economic Evaluation
NPV
NPV IRR
IRR
Scenario
Scenario
Development
Development Plan
Plan && Economic
Assumptions
Sensitivityanalysis
Sensitivity analysis
The variation of some key risk factors allows one to evaluate

the impact of those factors on the economic indicators.
This analysis gives a better feel

for the potential and the risks of the project.
70
Example of a sensitivity analysis / Tornado Chart
Sensitivity Analysis based on optimistic and pessimistic estimates
NPV = M$100 for Base Case
NPV
Most Likely Optimistic Pessimistic Optimistic Pessimistic Range
Variable Scenario Scenario Scenario Case Case
Selling Price $70/t $80/t $60/t M$140 M$60 M$80
Production 50 MMt 65 MMt 40 MMt M$150 M$55 M$95
Capital Costs M$950 M$855 M$1235 M$110 M$65 M$45
Operating Costs M$90 M$85 M$99 M$105 M$95 M$10
NPV Sensitivity Analysis
Production
Price
Capex

Opex
50 100 150
M$
71
Example of a sensitivity analysis / Spider Chart
Net Present Value Sensitivity

M$
800 Crude Price
Crude Price
700 Opex Rate

Royalty
Capex Tax
Income
600
500
400
300
200
100
-100
-40% -30% -20% -10% Base 10% 20% 30% 40%
Variation
72
Sensitivity analysis in investment decision
Enables discovery of maximum variations consistent with acceptability of

project.
Procedure ignores full dispersion of possible outcomes and ignores

probabilities attached to variations in primary variables.
Dependency causes difficulties in a sensitivity analysis because it is then not

strictly correct to consider errors in only one variable at a time. Two variables
are dependent if a knowledge of the value of one would influence the estimates
made for the other.
A sensitivity analysis is a useful first procedure in evaluating the risks inherent

in an investment opportunity.
It can be regarded as a way of quickly identifying those variables which

contribute most to the risk of the investment.
73
Methodology of quantitative risk analysis
Beyond sensitivity analysis
Identify key variables which contribute most to the project’s risk and
examine them more in detail.
If necessary, assign to the key variables ranges of values and

probability distributions, discrete or continuous, for a complete
description of uncertainties.
Conduct an evaluation, and recommend the best alternative

consistent with guidelines and constraints set by the management.
74
Methodology of quantitative risk analysis
Methods
Methods
Decision
DecisionTree
TreeAnalysis
Analysis
Monte
MonteCarlo
CarloSimulation
Simulation
Scenarios
ScenariosApproach
Approach

75
Discrete probabilistic approach: event trees
"Pessimistic" and "optimistic" estimates provide together with the best

estimate a first indication on the uncertainty attached to a particular variable.
A further step consists in assigning probabilities to the possible outcomes.

Such probabilities can be obtained either from statistical data or from
managerial judgement (in which case they are subjective and derive from the
company's expertise).
It leads to an event nod for the variable concerned. A combination of event

nods is an event tree.
The decision criteria becomes the NPV expected value which is the probability
weighted average of the branchs' NPV's. The result can be significantly different
from the most likely outcome.
However event trees become rapidly over complicated when they include
several parameters (price, volume, costs). They have to be simplified or one has
to revert to simulation techniques.
76
Discrete probabilistic approach: decision trees
Decision Tree Analysis (DTA) attempts to catch the flexibility available to

management in adjusting its decisions depending on the actual outcome of
certain parameters.
Solving a decision problem requires:

– To list the possible states of the system (states of nature) based on the
event nods of the parameters retained.
– To list the possible actions available to management.
– To list the possible consequences of each action depending on the state
of nature actually observed.
– To evaluate each consequence and choose the path (series of actions)
leading to the most interesting consequence.
The results are reported in a decision tree which is a succession of decision

and event nods. Decision trees need to be simplified by regrouping possible
states and possible actions in order not to become too complex. Regrouping

is a critical process due in particular to the fact that the required expertise is
scattered within different structures of a company.
77
Discrete probabilistic approach: decision trees

Decision Tree Analysis
attempts to catch, in a simple way, the flexibility available to management
in adjusting its decisions depending on the actual outcome of some risk factors.
NPV = 260 0.4

R NPV = 350
Exampleof
Example ofaaDecision
DecisionTree
Treefor
forthe
theAnalysis
Analysis
of Risk linked to Gas Reserves
of Risk linked to Gas Reserves 0.6
r NPV = 200
Development
NPV = 282 R NPV = 300

0.4
Decision
Decision
TECHNICAL Nod development
TECHNICAL Nod 0.6
STAFF
STAFF r NPV = 270
Good Delineation well
Communication
0.4
R & D NPV = 340
NPV = 292 0.6

r & d NPV = 260
MANAGEMENT
MANAGEMENT
78
Probability distributions and risk profiles
For a complete description of uncertainty, a probability distribution is used to

incorporate risk in the analysis, without adjustment to discount rate.
A probability distribution describes how probability is distributed over the range of

possible values of a variable: it is a curve which provides an indication of the
relative likelihoods of different values of the variable occurring.
Normal Lognormal Discrete
Probability
Probability
Probability
x x x
Uniform Step Rectangular Triangular Trapezoidal
Probability
Probability
Probability
Probability

x x x
x
79
Log-normal distribution
•1.0 •P99
•P95
•0.9 Min(P95):
Min (P95):48
48 Mode
Mode: :86
86 Max(P5):
Max (P5):265
265
•0.8
•Probability Density Function

•Cumulative Probability
•0.7 •mode
•0.6
•0.5 •median
•0.4 •mean
•0.3
•0.2
•0.1
•P5
•0.0 •P1
•0 •50 •100 •150 •200 •250 •300 •350 •400 •450
•Variable
Lognormal distributions can be described approximately by three points

Min Mode Max
Swanson’sLaw
Swanson’s Law
Mean≈≈0.30
Mean 0.30xxMin
Min++0.40
0.40xxMode
Mode++0.30
0.30xxMax
Max
80
Continuous probabilistic approach: Monte Carlo
Monte-Carlo simulation, aa purely
Monte-Carlo simulation, purely probabilistic
probabilistic approach:
approach:
¾¾ each
each risk factor: one
risk factor: one distribution
distribution of
of subjective
subjective probabilities.
probabilities.
¾
¾ aa simulation run: picks,
simulation run: picks, at
at random,
random, aa value
value for
for each
each variable,
variable,
and
and computes
computes the
the project’s
project’s NPV
NPV value.
value.
¾ repeat the
¾ repeat the process
process aa great
great number
number of
of times
times in
in order
order to
to
obtain a histogram of present values.
obtain a histogram of present values.
A project’s economic value is the weighted average

associated with all possible scenarios
NPV Distribution induced by the various risk factors.
TECHNICAL
TECHNICAL
STAFF
STAFF
Difficult
ItIt is
is very
very difficult
difficult to
to account
account forfor all
all the dependencies between
the dependencies between variables.
variables. Communication
It is impossible to the technical options
It is impossible to optimize the technical options for the development
optimize for the development
architecture
architecture and and production
production profiles.
profiles.
It is
It is impossible
impossible to identify the
to identify the contribution
contribution ofof aa given
given input
input to
to the
the output
output
value:
value: itit isis called
called the
the black box effect.
black box effect.

Black
Black box box effect
effect is
is aa critical drawback: itit prevents
critical drawback: experts in
prevents experts in charge
charge of
of MANAGEMENT
providing
providing the the subjective
subjective inputs
inputs and managers in
and managers in charge
charge of of making
making
MANAGEMENT
decisions
decisions from from building
building their
their own
own referential.
referential.
81
Looking for a way to keep it simple: Scenarios approach
A decision problem can be described with a natural approach through

three deterministic scenarios:
“Min”: “pessimistic” scenario NPVmin
“Mode”: “most probable” or base scenario NPVmode
“Max”: “optimistic” scenario NPVmax
DECISIONTHEORY
DECISION THEORY
ExpectedNet
Expected NetPresent
PresentValue
Value
ENPV <NPV>≅≅0.3
ENPV==<NPV> NPVmin++0.4
0.3NPV 0.4NPV
NPVmode++0.3
0.3NPV
NPVmax
min mode max
(Swanson’s Rule)
(Swanson’s Rule)
withaameasure
with measureof
ofthe
therisk
riskprovided
providedby
bythe
thestandard
standarddeviation
deviation
σσ≅≅1/3 (Vmax––VVmin))
1/3(V
max min
82
Studies
inthe
in thePetroleum
PetroleumIndustry
Industry
Contents
Contents
Introduction
Introduction

Fundamentals of
general methodology
methodology 33
Value creation
Value
creation and
and profitability
analysis 16
16
Principles of
Principles
of risk
risk analysis
methodology 68
68
Conclusion
Conclusion

From projects’
value to
to corporate
corporate financial
performance 84
84
From economics to financial performance
Capital
Employed
Shareholders Lenders
Company’s
Company’s Annual
Annual Financial
Financial Results
Results
Return on Average Capital Employed

These
These indicators
indicators measure
measure
the
the financial
performance
Return on Equity of
of the
the company.
company.
84
Balance sheet
Wealth of a Company and its Financing
ASSETS LIABILITIES
Provisions
Net Fixed Assets

Equity Capital
Operating Assets Debt Capital

(inventories + trade receivables)
Current Liabilities
Cash (trade payables)
Provisions or Allowances

company’s resources
set aside from the accounting point of view to face future charges
(decommissioning, deferred taxes, pension plans, exceptional elements, restructuring costs, etc.)
85
Balance sheet
ASSETS LIABILITIES
Provisions
Capital Employed
Capital Invested
Net Fixed Assets

Equity Capital
Debt Capital
Operating Working Capital - Cash
Operating Working Capital

= Operating Assets – Current Liabilities = Inventories + Trade Receivables – Trade Payables
86
Financial indicators
(Accounting)Result
(Accounting) ResultBefore-Tax
Before-Tax==Taxable Income==
TaxableIncome
OperatingRevenues
Operating Revenues--Operating
OperatingExpenses
Expenses
Operating --Depreciation
DepreciationCharges
Charges--Financial
FinancialCharges
Charges
Expenses Corporate Tax==
CorporateTax
TaxableIncome
Taxable Income xxIncome
IncomeTax
TaxRate
Rate
Depreciation
Charges
Operating
Revenues
EBITDA Corporate Tax
or
Gross EBIT Financial
Operating Profit or Charges
Operating After-Tax
Income Operating
Income Net Income

EBITDA,Earnings
EBITDA, Earningsbefore
beforeinterest,
interest,tax,
tax,depreciation
depreciation(tangible
(tangibleassets)
assets)and
andamortization
amortization(intangible
(intangibleassets)
assets)
isisthe
theresult
resultof
ofthe
theoperating
operatingcycle.
cycle.
EBIT, Earnings before interest
EBIT, Earnings before interest and andtax,
tax,isisthe
theresult
resultof
ofthe
theinvestment
investmentcycle
cycleand
andthe
theoperating
operatingcycle.
cycle.
87
Cash Flow or Funds From Operations (FFO)
CashFlow
Cash Flow==FFO
FFO==
NetIncome
Net Income++Depreciation
DepreciationCharges
Charges
Operating Cash flow is financing

Expenses that is internally generated by the company
Corporate Tax Loans

Loans Repayment
Operating Financial Charges
Revenues
Investments
Cash Flow Cash Flow
Statement of Sources and Uses of Funds

88
Operating income
Operating Income =
Operating Revenues
Operating - Operating Expenses
Expenses - Depreciation Charges
Operating Income, or
Depreciation EBIT, Earnings Before Interest and Tax,
Charges or operating profit, or operating result, or trading profit:
Operating
Revenues represents the earnings generated by investment cycle
and operating cycle for a given period.
The term “operating” contrasts with the term “financial”,

reflecting the distinction between the real world and the
Operating world of finance.
Income
Operating income is the product of the company’s
industrial and commercial activities before its financing

operations are taken into account.
89
After-tax operating income
Operating After-Tax Operating Income =

Expenses Operating Income
- Corporate Tax
Depreciation
Charges Tax ==t txx(R
CorporateTax
Corporate (R- -DD- -MM- -FC)
FC)
Operating
Revenues Corporate Tax
RR- -DD- -MM- -FC
FC==Taxable
TaxableIncome
Income
RR==Operating
OperatingRevenues
Revenues
After-Tax DD==Operating
OperatingExpenses
Expenses
Operating M = Depreciation Charges
M = Depreciation Charges
FC==Financial
FC FinancialCharges
Charges
Income
t t==income
incometax
taxrate
rate
90
Net operating income
Operating
Expenses Net Operating Income =
Operating Income
- Corporate Tax - Tax Shield
Depreciation
Charges Tax ==t txx(R
CorporateTax (R- -DD- -MM- -FC)
FC)
Operating Corporate
Revenues Theoretical Tax Shield ==t tFC
TaxShield FC
(without financial charges)
Tax
TheoreticalTax
Theoretical Tax==
CorporateTax
Corporate Tax++Tax
TaxShield
Shield==
Net t x (R - D - M)
t x (R - D - M)
Operating
Income

Remunerationthat
Remuneration thatthe
thecompany
companyisisable
ableto
toprovide
provideoverall
overallto
toall
allfunds
funds
91
ROACE (Return On Average Capital Employed)
Operating Liabilities Assets

Expenses
Average Capital Employed
Depreciation Debt
Charges ROACE Capital
Operating ROACE
Net
Revenues
Theoretical Tax Fixed Assets
Equity
Net Capital
Operating
Income Operating
Working Capital
ROACE==NET
ROACE NETOPERATING
OPERATINGINCOME
INCOME/ /AVERAGE
AVERAGECAPITAL
CAPITALEMPLOYED
EMPLOYED
Return on capital employed can also be considered as the return on equity if net debt is zero.
It is the most important indicator of value creation used in financial management.
92
Net income
Operating
Expenses
Net Income =
Depreciation Operating Income
Charges - Corporate Tax – Financial Charges
Operating
Revenues = Net Operating Income - (1-t) FC
Corporate Tax
= Before-Tax (Accounting) Result
Financial Charges - Corporate Tax
= After-Tax (Accounting) Result

Net Income

Remunerationthat
Remuneration thatthe
thecompany
companyis
isable
ableto
toprovide
provideto
toequity
equitycapital
capital
93
ROE (Return On Equity)
Operating Liabilities Assets

Expenses
Depreciation Debt
Charges Capital
Operating
Net
Revenues Corporate Tax Fixed Assets
ROE
ROE
Financial Charges
Equity
Capital
Net Income Operating
Working Capital
ROE==NET
ROE NETINCOME
INCOME/ /EQUITY
EQUITYCAPITAL
CAPITAL
94
Cost of debt and return on equity
ROCE
Cost of Debt Return On Equity
2% 4% 6% 8% 10% 12% 14% 16% 18%
10 % = 0 .5 * 8 % + 0 .5 * 12 %
Debt Capital Equity Capital
ROCE
2% 4% 6% 8% 10% 12% 14% 16% 18%
10 % = 0 .5 * 6 % + 0 .5 * 14 %

Return On Equity increases when Cost of Debt decreases

95
Debt ratio and return on equity

ROCE
2% 4% 6% 8% 10% 12% 14% 16% 18%
10 % = 0 .5 * 8 % + 0 .5 * 12 %

ROCE
2% 4% 6% 8% 10% 12% 14% 16% 18%
10 % = 0 .8 * 8 % + 0 .2 * 18 %

Financial Leverage
Return On Equity increases when Weight of Debt increases
96
Conclusion
Return on equity
is equal to return on capital employed plus a leverage effect.
If the use of debt allows one to reach a return on equity much higher
than the return on capital employed, it increases also the financial risk
of the shareholders.
In the long term, only a high return on capital employed will really create
value for the shareholders.
Valuecreation
Value creation

comesonly
comes onlythrough
through
theefficient
the efficientmanagement
managementof ofprojects.
projects.
97

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IFP Training course for PDVSA

MSc in refining engineering and gas

© 2009 IFP Training

Economic evaluations as a communication tool

Making the Final Decision

Long-Term Planning provides Objectives and Goals beyond the short-term

Consciousness of Future Expected Events

Therefore, management concentrates on those events

© 2009 IFP Training

Risk dynamics of the petroleum industry

© 2009 IFP Training

© 2009 IFP Training

Project sanction and phasing

Basic Engineering Phase

Construction & Commissioning Phase

© 2009 IFP Training

Cost estimate structure

© 2009 IFP Training

Economic evaluation of a project

 Economic Assumptions and Fiscal Framework

Fixed by the Management and linked to:

Capital Expenditures Operating Expenses

© 2009 IFP Training

Dependence of Receipts and Expenses of Projects A and B

Corporate finance and capital employed

Equity Capital Debt Capital

CONDITION FOR VALUE CREATION IN THE ABSENCE OF RISK

Investment projects must provide Project’s Rate of Return (%)

higher than Project’s

© 2009 IFP Training

Corporate finance and weighted average cost of capital

α Company’s debt ratio (Debt Capital / Total Capital)

WACC = i = 0.25*4% + 0.75*12% = 10%

© 2009 IFP Training

Cost of equity capital

• The shareholders anticipate some remuneration which depends on future

• A number of models of financial theory attempt to address this difficult

• Because of the higher risk faced by shareholders, their remuneration needs to

Cost of Equity Capital > Cost of Debt Capital

• Assumptions of Gordon Shapiro model

• With a rate of return demanded by shareholders, the stock value must be

• Cost of equity capital

with D0 dividend, V0 stock value, g dividend’s growth rate.

Example : D0 = 14, V0 = 100, g = 1%, then Cp = 15%

© 2009 IFP Training

Cost of equity capital / capital asset pricing model

• Assumptions of the capital asset pricing model

• The rate of return demanded by shareholders must be equal to the risk-free

• Cost of equity capital

Rf risk-free interest rate

Example : Rf = 6%, E(RM )= 11%, β = 1.8 then Cp = 15%

© 2009 IFP Training

Cash flows of an investment project

It is not valid to compare funds received or spent at different periods.

Amount that can be obtained in year n from saving

© 2009 IFP Training

Asset value is the present value of future net cash flows

© 2009 IFP Training

Corporate finance and discount rate of a company

Debt Capital Operational Division

Economic Assumptions and Fiscal Framework

WACC = i = 0.254% + 0.7512% = 10%

Single independent project

Choosing between projects

Reasons for analyzing costs for an investment project:

Project's Discounted Cost

After-Tax WACC = i = 0.251.6% + 0.7512% = 9.4%