Project Parameters

Project Parameters
The Cash flow is most appropriate methodology for evaluating long term investment and that time is an
important factor in determining the value of individual cash flow. An investment or project may include
a large number of cash flows and when these are related to time in an appropriate manner, the whole
may be represented by a series of Net Cash Flows [NCF’s].
Parameters for measuring value of profitability divided into 2 groups: Discounted and undiscounted
Undiscounted: “Payback”, “Profit to investment Ratio”, “CAPEX per barrel”, “Maximum capital outlay”
Discounted: when time value of is included, “Net Present Value”, “Internal Rate of Return”, “NPV index”,
“Annual capital charge”
Before making investment decision, the following stages should be done.
1) Project screening- Screening involves a company in the testing of each available project against
a set of appropriate criteria or standards, to determine whether these opportunities are suitable
or profitable.
2) Project ranking- Ranking follows and requires comparison between suitable projects to
determine the best candidates for investment.
3) Transaction value
Cash flow models: MOD, RT
MOD (realistic) =Money of the day, incorporates the expenditures and revenues for each project year,
using currency units [£, $] appropriate to that year. Consequently, with inflation, the purchasing power
of the currency units in the model varies from year to year. Derivation of such a cash flow, from the
physical project model, requires an explicit assumption about future rates of price inflation. Project cost
normally increases with inflation, and this may be modelled, using RPI or some other price index.
Revenues may or may not change with inflation. Commodity markets, such as oil, are dominated by
supply / demand interaction, and price may be insensitive to inflation. Model data may also be used
directly to calculate tax liability, since official tax calculation is based on “mod” revenues and costs. The
advantage of having a cash flow model in “mod” terms is that the model can interface directly with the
world outside the project. The disadvantage of having a cash flow in “mod” terms is that the purchasing
power of the data varies from year to year.
RT(optimistic) =Real term, incorporates the expenditures and revenues for each project year, using
currency units [£, $ etc] of constant purchasing power. The advantage of having a cash flow model in
“real” terms is that the NCF derived from it is also in “real” terms. The disadvantage of having a cash
flow model in “real’ terms is that the model does not relate to the world outside.
Overview of MOD and RT : MOD uses currency with appropriate to expenditures of specific year;
purchasing power of currency varies with inflation. RT uses constant purchasing power. For long term
decisions usually based on RT model.
Depending on the nature of business and investment, some organisations use ”mod”, others use “real”
data. No matter which one is used, data can easily be converted from “mod” to “real” or vice-versa.
Accounting systems are usually based on “mod” data and this relates to conventional budgeting and
annual reports, banking and tax calculation. Measures of value or profitability should be based on
increasing purchasing power. If the model is in “real” terms, the derived NCF will also be in “real” terms
with the same currency units. If the model is in “mod” terms, the NCF derived from it will also be in
“mod” terms. At this stage, the NCF may be converted to “real” terms using simple conversion factors
based on inflation data. Derived measures of profitability are then based on purchasing power as
before. If analysis proceeds with the NCF in “mod” terms, any derived measure of value or profitability
becomes distorted by inflation.
Model construction
A cash flow model is normally used to derive a range of economic parameters with a view to making an
investment decision. It is always important to make the best use of available data and to ensure that
the analysis is appropriate to the problem or application.
1) Physical model- starting point for any cash flow is a model of the physical project, incorporating
best estimates for development and production phases and all the relevant timing. The quantity
and quality of data available will reflect the nature of the project and the current stage of
investigation or development.
2) Relevant data - Any decision to invest changes a pre-existing world. It is fundamental to the cash
flow method to distinguish between those cash flows, which result from the decision or
investment and those, which would have occurred regardless. Only those, which are dependent
on the decision, are relevant.
3) Cash flow - Cash flows involve the physical [or electronic] transfer of funds from one account to
another. Depreciation is not a cash flow. Costs may be estimates, derived from previous
experience or quotes from potential suppliers. Revenues are inevitably further into the future
and subject to greater uncertainty.
4) Net cash flow- NCF is the aggregate cash flow for a specified time period. The currency units for
NCF are the same as for the cash flows from which it is derived. Thus, if cash flow in “mod”, NCF
will also be in “mod”. To simplify further analysis, it is preferable for NCF to be converted to
“real” terms at this stage, so that all derived parameters are related to constant purchasing
power
5) Timing
TCS= terminal cash surplus
MCO= Maximum capital outlay
NPV=R(t)/(1+i)^t where “i” is discount rate
PI ratio= TSC/MCO where MCO is best measures of investment

Project Parameters

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Project Parameters

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Project Parameters

Before making investment decision, the following stages should be done.

Cash flow models: MOD, RT

TCS= terminal cash surplus

MCO= Maximum capital outlay

NPV=R(t)/(1+i)^t where “i” is discount rate

PI ratio= TSC/MCO where MCO is best measures of investment

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