OT30335 - Capital Gains

Valuation of Oil Assets (including shares). Methodology. Discount Rates and Risking.

Other Measures of Value

There is a tendency to concentrate on the discount rate and the resulting NPV. However, there are other measures of worth which decide whether or not a project goes ahead: the internal rate of return (IRR), the growth rate return, the index of present value, and the time to pay back. Of these other measures probably the most significant is the IRR - the discount rate which, if applied, produces a nil NPV. Companies usually have a hurdle rate which is a minimum IRR. Wood MacKenzie describe the hurdle rate as the “required rate for return which must be exceeded if a project is to be approved”.

A hurdle rate is significant in deciding whether or not a project will take place, and whether or not it is a commercial proposition for the company - and therefore whether it has any NPV. However, it should be borne in mind that if a project can be seen as an incremental investment it could conceivably take place even if the hurdle rate is not achieved.

In-house Rates

Companies may have an established discount rate which they apply to all acquisitions irrespective of the degree of risk. When dealing with such a case on a valuation it may be difficult to persuade the company that a particular project warrants a higher discount. In these circumstances it may be more practical to accept the in-house rate but reflect the additional risk in other ways - risk the reserves or risk the final result.