An Oil & Gas investor consider various investing options and various technical alternatives before finalization of a particular technical option. They have to consider financial viability of the project through various means.
The various alternatives varies according to their following properties :-
- Capital cost investment
- Time duration of project construction.
- Return on the investment
- Time to Recover investment
All options have different attributes, out of them only one has to be selected which is the best.
Financial advisor uses different tools and different parameter to check profitability of the option.
Below are the terms or parameters frequently used for Financial analysis.
- NPV (Net Present Value) :-
It is the difference between the present value of cash outflows (investment) and the present value of cash inflows (income) over a period of time.
A project desire investment at different stages . After completion of the project , revenue generation is again at different stage and different life cycle of project. The value of currency is different at different stage. NPV is present value of all type of outgoing and incoming money.
Below is mathematical formula to convert each year cash flow to a present value.
r= Interest rate or discount rate
n= no of years
NPV is used to compare financial health of various alternatives.
2. IRR (Internal Rate of Return):-
This is the discount rate at which NPV turn zero. The higher IRR means project is more desirable.
Definitely the industry involves with more risk demand more IRR. However IRR is not alone a single parameter to finalize project option.
In excel IRR can be calculated using function IRR or Goal Seek.
At some occasion, considering only IRR as decision maker may lead to poor decision especially if the options are with time time duration.
3. Payback period:-
It is the duration of time to recover the cost of investment. The outflow and inflow are equal.
This is answer to the “How long until we make our money back?”.
Option with lower the payback period is more convincing and attractive.
4. Profitability Index:-
Another names of Profitability index are “Profit Investment Ratio” and “Value investment Ratio”.
It is calculated as below:-
It is return on the each unit of investment. For example :-
The profitability index is 1.15 an investment of 1 USD is going to return 1.15 USD i.e. a gain of 0.15 USD.
A profitability index of more than 1 is only acceptable. And profitability index below is not acceptable.
In reality there are various factors and various term used for final consideration of project viability.