Page 368 - Hydrocarbon Exploration and Production Second Edition

Petroleum Economics 355

The benefit of this presentation is that it gives an indication of how sensitive
the NPV is to oil price and discount rate. For example if the 20%, $40/bbl NPV is
positive, but the 20%, $20/bbl NPV is negative, it indicates that at an oil price
somewhere between $20 and $40/bbl the project breaks even (i.e. has an NPVof $0
at 20% discount rate).
If 10% is the cost of capital to the company, then the NPV(10) represents the real
measure of the project value. That is, whatever positive NPV is achieved after
discounting at the cost of capital, is the net value generated by the project. The 20%
discount rate sensitivity is applied to include the risks inherent in the business, and
would be a typical discount rate used for screening projects. Screening is discussed
in more detail in Section 14.5.

14.3.5. The impact of discount rate on NPV
As the discount rate increases then the NPV is reduced. The following diagram
shows the cashflow from the previous example (assuming an oil price of $20/bbl
and ignoring the effect of inflation) at four different mid-year discount rates (10, 20,
25, 30%).
At a specific discount rate the NPV is reduced to zero. This discount rate is
called the internal rate of return (IRR).
The higher the IRR, the more robust the project is, that is the more risk it can
withstand before the IRR is eroded down to the level of the cost of capital. If the
project IRR does not meet the cost of capital, then the project is unable to repay the
cost of financing (assuming it is funded at the normal cost of capital to the company).
IRR is therefore often used as a screening criterion, discussed in Section 14.5.
One way of calculating the IRR is to plot the NPV against discount rate, and to
extrapolate/interpolate to estimate the discount rate at which the NPV becomes
zero, as in the present value profile in Figure 14.11. The alternative method of
calculating IRR is by using spreadsheet software (@ IRR function on Lotus
1-2-3, ¼ IRR function on Microsoft Excel). This function uses an iteration

200

100
NPV $m

0
10 20 30

Discount Rate %
-100
Figure 14.11 The present value pro¢le.