Capital gains: valuation of oil assets including shares: the discount rate and risking - other methods of risking
Applying a discount rate is not the only way of risking a discovery. The reserves can also be risked - using, say, a percentage of the reserves in a DCF analysis. Alternatively the final result can be risked - carrying out a full DCF on a project which has, say, only a 60:40 chance of being developed and reducing the NPV by 40%. Where there is a choice between risking the reserves or risking the final result, the latter may be more appropriate if there are contemporary assumptions about development, opex and capex which depend on the full reserves being developed.
Weighted Average Cost of Capital (WACC)
This is an investment tool which is used to determine the required rate of return for investors and shareholders - the cost of capital is calculated as a weighted average of the costs of equity and debt adjusted for leverage, risk and the effect on tax of the costs of debt. This is used as a financial hurdle rate by investors in the company, to reflect a perceived level of risk. The level of debt will impact returns achieved by investors. The essential point to note is that different capital structures will yield different WACCs.
In the case of a company, this is unsuitable as it would attempt to value the company using discount factors based upon investor risk assumption and capital structure, which will not necessarily reflect the underlying value or risk of the company’s assets. WACC also requires assumptions about investors’ expected returns in order to calculate a discount rate which is supposed to reflect the perceived risk, and those assumptions may not be appropriate in considering a market value.
In the case of a project, another of the difficulties about the WACC approach is that the project being evaluated may have a higher risk factor than the average of the company’s existing projects, and the method would not, therefore, give an acceptably accurate result. Thus individual projects should be considered separately, and WACC is not appropriate.
The Capital Asset Pricing Model (CAPM) will similarly inform an investor hurdle rate and may be deployed as an alternative but there are similar problems with it. This discount method’s rate is essentially derived from the stock market and not from the risks attaching to specific projects.