Page 366 - Hydrocarbon Exploration and Production Second Edition

Petroleum Economics 353

14.3.2. Setting the discount rate
In the above example, the discount rate used was the annual compound interest rate
offered by the bank. In business investment opportunities the appropriate discount
rate is the cost of capital to the company. This may be calculated in different ways, but
should always reflect how much it costs the oil company to borrow the money
which it uses to invest in its projects. This may be a weighted average of the cost of
the share capital and loan capital of a company.
If the company is fully self-financing for its new ventures, then the appropriate
discount rate would be the rate of return of the alternative investment opportunities
(e.g. other projects) since this opportunity is foregone by undertaking the proposed
project. This represents the opportunity cost of the capital. It is assumed that the return
from the alternative projects is at least equal to the cost of capital to the company,
otherwise the alternative projects should not be undertaken.

14.3.3. Discounting: the procedure

Once the concept of discounting is accepted, the procedure becomes mechanical.
The general formula for discounting a flow of money occurring in t years time (c t ) to its
PV (c o ) assuming a discount rate (r)is
c t t
c o ¼ t or c o ¼ c t ð1 þ rÞ
ð1 þ rÞ
t
the factor 1/(1+r) is called the discount factor.
Since this is a purely mechanical operation it can be performed using the above
equation, or by looking up the appropriate discount factor in discount tables, or by
setting the problem up on a spreadsheet. Two types of discount factors are presented
for full year and half year discounting.
If the reference date is set at the beginning of the year (e.g. 1.1.2008) then full
year discount factors imply that t is a whole number and that cashflows occur in
lump sums at the end of each year. If the cashflow occurs uniformly throughout the
year and the reference date is the beginning of the year then mid-year discount
factors are more appropriate, in which case the discounting equation would be
c t
c o ¼ t 0:5
ð1 þ rÞ
1/(1+r) t 0.5 is the mid-year discount factor.
Discounting can also be performed, of course, using a programmable calculator
or a spreadsheet such as Lotus 1-2-3 or Microsoft Excel. The ‘NPV’ function is
worth noting. In Excel, for example, a string of numbers (net cashflows in our case)
can be discounted at a chosen discount rate (r) by using the function
¼ NPVðr%; cell references for net cashflowsÞ e:g: ¼ NPVð7%; B2 : B20Þ
By default, Excel will assume the net cashflows occur at the end of each year.
If mid-year discounting is required, this can be adapted as follows

0:5
¼ NPVð7%; B2 : B20Þ ð1 þ rÞ