Lecture 5: Financial Measures & Profitability Analysis

Dr. Jonathan Atuquaye Quaye

Department of Petroleum Engineering
College of Engineering
KNUST, Kumasi.
Email: jaquaye@[Link]
 Why Profitability Analysis

The Engineer’s Dilemma:

❑ Technical success does not guarantee economic success.
❑ Every engineering solution must be evaluated for its economic merit.
❑ In petroleum projects, profitability is the primary driver for decisions on
exploration, drilling, production, and refining.

Core Question:
“Is this project financially worthwhile, and is it the best use of limited
capital?”

Key Tools:
Annual Rate of Return (ARR), Payout Period (PP), Discounted Cash Flow
Rate of Return (DCFR), Net Present Value (NPV).
 Annual Rate of Return (ARR)
Definition:
A simple ratio of average annual profit to the initial investment. Also known as Return
on Investment (ROI).

Formula:
ARR (%) = (Average Annual Profit / Initial Investment) * 100

Key Features:
❑ Non-discounting method: Does not consider the time value of money.
❑ Simple and intuitive.
❑ Often used for a quick, preliminary screening of projects.

Decision Criterion:
A project is acceptable if its ARR exceeds a company's minimum acceptable rate of
return (MARR) or "hurdle rate."
 ARR Calculation: Example

❑ Initial Investment (P): $100,000

❑ Project Life (n): 5 years
❑ Annual Net Cash Flows: Year 1: $30,000, Year 2: $25,000, Year 3: $20,000,
Year 4: $25,000, Year 5: $30,000.
❑ Total Profit over 5 years = $130,000

Calculation:
1. Average Annual Profit = Total Profit / Project Life = $130,000 / 5 = $26,000

2. ARR = ($26,000 / $100,000) * 100 = 26%

Interpretation:
If the company's MARR is 15%, this project (26% ARR) appears attractive
based on this simple measure.
ARR Calculation: Example
ARR Calculation: Example
 Payout Period (Payback Period)
Definition:
The time required for the cumulative net cash flows from a project to equal the
initial investment. Cash flow would imply the sum of cash revenues and
expenditures over a period.

Formula (for uniform cash flows):

Payout Period (Years) = Initial Investment / Annual Cash Flow

Key Features:
❑ Liquidity focus: Measures how fast the capital is recovered.
❑ Risk indicator: Shorter payback = lower exposure to risk and uncertainty.
❑ Ignores cash flows after payback and the time value of money.

Decision Criterion:
A project is acceptable if its Payout Period is less than a company's maximum
acceptable period.
Payout Period (Payback Period)

Illustration of payout period

(P.P.)
 Payout Period (Payback Period)
❑ Investment Sequence:
First, capital is invested in land (if needed).
Second, capital is spent on depreciable assets (e.g., construction).
Third, working capital is required for the startup and production.

❑ Definition of Payout/Payback Period:

It is the time (from point 3, the start of production) until the cumulative cash flow recovers the total
cumulative expenditure (land, depreciable assets, and working capital). This is point 4.
However, the payout period is officially defined as the time needed to recover the depreciable capital
only.

❑ Use & Importance in Oil Companies:

It's a key tool for rating and screening capital investment proposals.
Companies prefer short payback periods due to future uncertainty and cash flow needs.
It sets investment hurdles (e.g., ≤3 years for refinery units, ≤5 years for acquiring a subsidiary).

❑ Major Drawbacks of the Payback Method:

It ignores the project's total useful life and any income generated after the payback period.
It is not a measure of profitability or earning power.
Consequently, it can lead to suboptimal investment decisions that don’t maximise long-term company
value.
 Payout Period Calculation: Example 1

Project Data (Non-uniform cash flows):

❑ Initial Investment: $50,000
❑ Annual Cash Flows: Year 1: $10,000, Year 2: $15,000, Year 3: $20,000, Year 4:
$25,000.

Calculation (Cumulative Cash Flow):

❑ End of Year 1: $10,000
❑ End of Year 2: $10,000 + $15,000 = $25,000
❑ End of Year 3: $25,000 + $20,000 = $45,000
❑ During Year 4: Need $5,000 to reach $50,000. Cash flow in Year 4 is $25,000.
❑ Payout = 3 years + ($5,000 / $25,000) = 3.2 years

Interpretation:
Capital is recovered in just over 3 years. Useful for high-risk environments.
Payout Period Calculation: Example 2
 Payout Period Calculation: Example 3
❑ The pay period index would thus
recommend project 1 in favour of project
2 (fewer years are required to recover the
same initial capital increment).

❑ However, project 1, as shown in Table

6.2, ceases to generate any cash flow
after the sixth year, while project 2
continues, through the added cash flow,
to generate $400,000 each year after the
investment has been paid back in full at
the end of the sixth year (P.P. is 7 years).

❑ It is pointless to select project 1 because

over the period from year 7 to year 10,
$1.2 million would be generated by
project 2, which makes a total of $0.8
million more by project 2 over project 1
for the 10 years.
 Payout Period Calculation: Example 4

❑ As far as the P.P. as a criterion for choice, the number of years to recover the depreciable capital
is the same for both types of boilers.
❑ However, the recovery of investment for boiler 1 is faster than for boiler 2 (for example,
compare $20,000 to $5,000 for the first year).
❑ Therefore, from the standpoint of the cost of money (time value of money), investment in
boiler 1 is preferable to investment in boiler 2.
 Payout Period Calculation: Example 4
❑This example points out that when
using the payout period method, oil
management should also observe
the rapidity of cash flows between
alternatives.

❑The alternatives may have the same

number of years to pay back as they
do here, but one may be more
❑ This could be an excellent point in favour of favourable than the other because
investment in one alternative over another when the largest amount of cash flow
both have approximately the same payout comes in the first few years.
periods.

❑ It could be a strong factor in selection of one,

especially if a greater amount of cash “back” is
needed early in the investment.
 The Time Value of Money (TVM) – A Critical Refresher
Core Principle:
A dollar today is worth more than a dollar in the future.
❑ Reason 1: Inflation erodes purchasing power.
❑ Reason 2: Capital can earn interest (opportunity cost).
❑ Reason 3: Future cash flows are uncertain (risk).

Implication for Profitability:

We must discount future cash flows to their Present Value (PV) for a fair
comparison.

Key TVM Formulas (from Chapter 4):

❑ Future Value: F = P (1 + i)^n
❑ Present Value: P = F / (1 + i)^n or P = F * (1 + i)^-n
❑ Where: P=Present Value, F=Future Value, i=discount (interest) rate,
n=number of periods.
 Discounted Cash Flow Rate of Return (DCFR)
Also Known As: Internal Rate of Return (IRR).

❑ From the computational point of view, D.C.F.R. cannot be expressed by an equation or

formula, like the previous methods. A three-step procedure involving trial and error is
required to solve such problems.

❑ Definition: The discount rate (i*) that makes the Net Present Value (NPV) of all cash flows
from a project equal to ZERO.

Formula (Conceptual):
NPV = 0 = Σ [Net Cash Flow_t / (1 + DCFR)^t] - Initial Investment

Interpretation: DCFR is the project-generated effective compound interest rate. It

represents the profitability of the project itself.
Decision Criterion: Accept the project if DCFR > MARR. Choose the project with the highest
DCFR when mutually exclusive.
 Calculating DCFR: Trial-and-Error Method

Project: Invest $10,000 today. Receive $3,000/year for 5 years.

Step 1: Try i = 10%
❑ PV of Cash Flows = $3,000 * [1 - (1.10)^-5] / 0.10 = $3,000 * 3.7908 =
$11,372
❑ NPV = $11,372 - $10,000 = +$1,372

Step 2: Try i = 15% (NPV must become zero or negative)

❑ PV = $3,000 * [1 - (1.15)^-5] / 0.15 = $3,000 * 3.3522 = $10,057
❑ NPV = $10,057 - $10,000 = +$57 (Very close to zero)

Step 3: Try i = 15.1%

❑ NPV would be slightly negative.
❑ Conclusion: DCFR ≈ 15.1%. If MARR is 12%, this project is excellent.
Calculating DCFR: Trial-and-Error Method
Calculating DCFR: Trial-and-Error Method
Calculating DCFR: Trial-and-Error Method
 Net Present Value (NPV)
Definition: The difference between the present value of all future cash inflows and
the present value of all cash outflows (including initial investment).

Formula:
NPV = Σ [Cash Inflow / (1 + i)^t] - Σ [Cash Outflow / (1 + i)^t]
Where i is the chosen discount rate (MARR).

Key Concept:
NPV measures the project's net present value in today's dollars, after accounting
for the required rate of return (MARR).

Decision Criterion:
❑ NPV > 0: Project adds value. ACCEPT.
❑ NPV = 0: Project meets MARR exactly (break-even).
❑ NPV < 0: Project destroys value. REJECT
Net Present Value (NPV) - Example
 NPV Calculation & Profile
❑ Project A: Initial Cost = $100,000. Cash Inflows
Years 1-5 = $30,000/yr.
❑ MARR (i) = 10%.
Calculation:
❑ PV of Inflows = $30,000 * Annuity Factor (10%, 5y) =
$30,000 * 3.7908 = $113,724
❑ NPV = $113,724 - $100,000 = +$13,724

Interpretation:
The project generates a present value surplus of
$13,724 after providing a 10% return. ACCEPT.
NPV Profile: A graph of NPV (Y-axis) vs. Discount Rate
(X-axis).
❑ Shows how NPV changes with i.
❑ The point where the profile crosses the X-axis
(NPV=0) is the DCFR/IRR.
 Comparing NPV and DCFR

Discounted Cash Flow Rate

Criterion Net Present Value (NPV)
(DCFR/IRR)
Definition Absolute value in currency ($). Relative rate of return (%).
Assumes cash flows are
Assumes cash flows are reinvested
Reinvestment Assumption reinvested at the discount rate
at the project's own IRR.
(MARR).
Accept if IRR > MARR. Maximise
Decision Rule Accept if NPV > 0. Maximise NPV.
IRR.
Accurately reflects project size. A May favour smaller projects with
Scale of Project
large NPV adds more value. high % returns but low total value.
Unique solution for a given Can have multiple IRRs for non-
Multiple Solutions
discount rate. conventional cash flows.
Best for selecting among Excellent for ranking independent
Primary Use
mutually exclusive projects. projects and understanding yield.
 Case Study: Choosing an Offshore Platform
Scenario: Two designs for a production platform.
❑ Option X (Fixed Platform): Higher initial cost ($50M), lower operating costs ($5M/yr), life 15
years.
❑ Option Y (Floating Platform): Lower initial cost ($30M), higher operating costs ($8M/yr), life
15 years.
❑ MARR = 12%
Analysis:
1. Calculate Annual Net Cash Flow for each.
2. Compute NPV for both at i=12%.
3. Compute DCFR for both.
Result (Illustrative):
❑ NPV_X = +$8.2M, NPV_Y = +$5.1M.
❑ DCFR_X = 16.5%, DCFR_Y = 18.0%.
Conflict:
DCFR favours Option Y (18% > 16.5%). NPV favours Option X (+$8.2M > +$5.1M).

Decision:
Choose Option X (Higher NPV). It creates more total wealth for the company, which is the
goal.
 Summary & Key Takeaways

1. ARR & Payout are simple, non-discounting methods useful for quick
screening and liquidity/risk assessment.
2. DCFR (IRR) is a powerful, intuitive metric that gives the project's
effective interest rate. Accept if IRR > MARR.
3. NPV is the most theoretically sound measure. It calculates the
absolute dollar value added to the firm. Maximise NPV.
4. For mutually exclusive projects, NPV is the primary decision
criterion, as it selects the project that maximises shareholder value.
5. Always conduct profitability analysis using multiple measures to
get a complete picture of a petroleum project's economic potential.
 Assignment
Part A: Annual Rate of Return (ARR)
A petroleum production project requires an initial investment of $500,000. The expected net cash
flows over its 6-year life are as follows:

Year Net Cash Flow ($)

1 120,000
2 150,000
3 180,000
4 160,000
5 140,000
6 100,000
Required:

❑ Calculate the total profit over the project’s life.

❑ Compute the Average Annual Profit.
❑ Determine the Annual Rate of Return (ARR) on the initial investment.
❑ If the company’s Minimum Acceptable Rate of Return (MARR) is 18%, should the project be
accepted based on ARR? Why or why not?
 Assignment
Part B: Payout Period (PP)
Consider two competing small-scale refinery upgrade projects with the following cash flow
profiles:

Year Project Alpha ($) Project Beta ($)

0 -200,000 -200,000
1 60,000 30,000
2 80,000 50,000
3 70,000 90,000
4 50,000 100,000
5 40,000 80,000
Required:

❑ Calculate the Payout Period for Project Alpha.

❑ Calculate the Payout Period for Project Beta.
❑ Which project would be preferred based only on the Payout Period criterion?
❑ Discuss two limitations of using the Payout Period method for investment decisions.
 Assignment

Part C: Discounted Cash Flow Rate of Return (DCFR/IRR)

An exploration well requires an initial outlay of $1,200,000. It is expected to
generate uniform annual net cash inflows of $320,000 for the next 5 years.

Required:

❑ Set up the NPV equation to solve for DCFR.

❑ Using a trial-and-error approach (show at least two trials), estimate the DCFR
for this project.
❑ If the company’s MARR is 12%, is the project economically viable based on
DCFR?
 Assignment

Part D: Net Present Value (NPV)

Using the same data from Part C:

Required:

❑ Calculate the NPV of the project at the company’s MARR of 12%.

❑ Interpret the NPV result in economic terms.
❑ If another similar project has an NPV of $150,000 at the same
MARR, which one should be selected if they are mutually
exclusive? Why?
 Assignment
Part E: Integrated Case Study – Offshore Development Option
The engineering team is evaluating two design concepts for a marginal offshore field:

Option 1 – Fixed Platform

Initial investment: $75 million
Annual operating cost: $4 million
Annual revenue: $20 million
Project life: 10 years

Option 2 – Floating Production System

Initial investment: $50 million
Annual operating cost: $7 million
Annual revenue: $18 million
Project life: 10 years

The company’s MARR is 15%.

Required:
❑ Calculate the annual net cash flow for each option.
❑ Compute the NPV for both options.
❑ Compute the DCFR for both options (use approximation or interpolation).
Based on your results:
❑ Which option is preferred under the NPV criterion?
❑ Which option is preferred under the DCFR criterion?
❑ If there is a conflict, explain which criterion should be followed and why.
 Assignment

Part F: Short Conceptual Questions

Why is the time value of money a critical concept in petroleum project
economics?

Explain why a project with a shorter Payout Period is generally

considered less risky.

In what situation might the NPV and DCFR methods give conflicting
rankings for two projects? How should such a conflict be resolved?