Capital gains: valuation of oil assets including shares: the discount rate and risking
The discount rate will have a significant effect on NPVs. The discount rate will cover the monetary risk factors, but there are other risks that need to be considered and factored in. These may include the degree of certainty on the level of reserves, their recoverability and the degree to which development is contingent on other events.
One way or another all risks and uncertainties need to be accounted for in the discount factor, the risking of reserves or in some other way.
Discount rates can be real or nominal (nominal is real plus inflation, that is if the real rate is 10% and inflation is 8% the nominal rate will be 18.8%). In theory the inflation element in a cash flow should not matter as it should be stripped out when the discount rate is applied but note:
- in practice it may matter because the inflation element in the nominal rate may not match the inflation rate applied to expenditure and income; and
- a DCF analysis on the basis of a real rate with no inflation can impact on the tax calculation and the offset of tax losses brought forward.