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==Discounted cash flow rate of return==

==Discounted cash flow rate of return==

''Discounted cash flow rate of return'' (DCFROR), or internal rate of return, is calculated by a trial-and-error method. In this method, different discount rates—and thus present value (PV) factors—are inserted in the cash flow model to yield a series of NPVs, beginning with a discount rate of zero (equals undiscounted net cash flow stream). For project cash flows, such as our two examples, the cumulative NPV of a project will decline with successively higher discount rates (Figure 1). The point at which the declining curve intersects the zero present value line corresponds to the DCFROR of the project. For complex projects involving subsequent [[enhanced oil recovery]] additions, the resulting dual rate problem may generate more than one DCFROR.

[[file:key-economic-parameters_fig1.png|left|thumb|{{figure number|1}}Present value profile and determination of DCFROR for example development well and example multiwell extension project.]]

[[file:key-economic-parameters_fig1.png|thumb|{{figure number|1}}Present value profile and determination of DCFROR for example development well and example multiwell extension project.]]

''Discounted cash flow rate of return'' (DCFROR), or internal rate of return, is calculated by a trial-and-error method. In this method, different discount rates—and thus present value (PV) factors—are inserted in the cash flow model to yield a series of NPVs, beginning with a discount rate of zero (equals undiscounted net cash flow stream). For project cash flows, such as our two examples, the cumulative NPV of a project will decline with successively higher discount rates ([[:file:key-economic-parameters_fig1.png|Figure 1]]). The point at which the declining curve intersects the zero present value line corresponds to the DCFROR of the project. For complex projects involving subsequent [[enhanced oil recovery]] additions, the resulting dual rate problem may generate more than one DCFROR.

If treasury growth<ref name=pt02r3 /> is the goal of the firm, selecting projects based on DCFROR will not necessarily result in the best selection of projects. Thompson and Wright<ref name=pt02r16 /> discuss the use of DCFROR as a decision criterion and the reinvestment assumption.

If treasury growth<ref name=pt02r3 /> is the goal of the firm, selecting projects based on DCFROR will not necessarily result in the best selection of projects. Thompson and Wright<ref name=pt02r16 /> discuss the use of DCFROR as a decision criterion and the reinvestment assumption.

It is the authors' opinion that DCFROR should not be used as a “risking measure”—this measure has nothing whatever to do with project risk! Some firms think (incorrectly) that by setting high DCFROR hurdle rates, they are selecting the better projects. Ideally, such hurdle rates should reflect the current real earning performance of the firm. For a discussion of the use of high hurdle rates to account for risk, see Thompson and Wright.<ref name=pt02r17>Thompson, R. S., Wright, J. D., 1992, Oil and gas property evaluation, 3rd ed.: Golden, CO, Thompson-Wright Associates, in prep.</ref> Excessively high DCFROR hurdles in fact tend to favor short-term, lower reserve, high profit projects (which, upon project completion, the company has a hard time replacing) at the expense of long-term, larger reserve projects—the kind of projects that build corporations. ''DCFROR is only recommended as a minimum hurdle that all proposed projects must clear to be considered''.

It is the authors' opinion that DCFROR should not be used as a “risking measure”—this measure has nothing whatever to do with project risk! Some firms think (incorrectly) that by setting high DCFROR hurdle rates, they are selecting the better projects. Ideally, such hurdle rates should reflect the current real earning performance of the firm. For a discussion of the use of high hurdle rates to account for risk, see Thompson and Wright.<ref name=pt02r17>Thompson, R. S., Wright, J. D., 1992, Oil and gas property evaluation, 3rd ed.: Golden, CO, Thompson-Wright Associates, in prep.</ref> Excessively high DCFROR hurdles in fact tend to favor short-term, lower reserve, high profit projects (which, upon project completion, the company has a hard time replacing) at the expense of long-term, larger reserve projects—the kind of projects that build corporations. ''DCFROR is only recommended as a minimum hurdle that all proposed projects must clear to be considered''.

The present value profile for the two example cases (Figure 1) shows graphically that the DCFROR for the development well is approximately 45% and that the DCFROR for the extension project is approximately 28%. These two DCFRORs demonstrate an important point about development well economics and exploration economics. Development wells are evaluated on an incremental basis. If over the long term the firm is to generate sufficient cash flow from production to sustain a continuing exploratory program, the DCFROR for the development well must be greater than the DCFROR for the exploration project. This is true because the development well must (1) earn enough to pay for itself, (2) earn a satisfactory return as an investment, and (3) provide additional earnings proportionally equivalent to at least the true cost of the exploratory effort required to discover it (including exploratory dry holes).

The present value profile for the two example cases ([[:file:key-economic-parameters_fig1.png|Figure 1]]) shows graphically that the DCFROR for the development well is approximately 45% and that the DCFROR for the extension project is approximately 28%. These two DCFRORs demonstrate an important point about development well economics and exploration economics. Development wells are evaluated on an incremental basis. If over the long term the firm is to generate sufficient cash flow from production to sustain a continuing exploratory program, the DCFROR for the development well must be greater than the DCFROR for the exploration project. This is true because the development well must (1) earn enough to pay for itself, (2) earn a satisfactory return as an investment, and (3) provide additional earnings proportionally equivalent to at least the true cost of the exploratory effort required to discover it (including exploratory dry holes).

Finally, in capital budgeting, management must remember that exploration and prospect generation are long-term commitments. The capital commitment for exploration should not be turned on and off from year to year. Considerable lead time is required for geological and geophysical studies. One measure of the success of an exploratory program is by a historical analysis of past exploration activities including the actual development expenditures. The result should be a DCFROR greater than the minimum hurdle rate. On the other hand, a historical analysis of the development costs and subsequent production should result in higher historical DCFRORs than the total exploration program since the exploratory costs would be left out in this analysis.

Finally, in capital budgeting, management must remember that exploration and prospect generation are long-term commitments. The capital commitment for exploration should not be turned on and off from year to year. Considerable lead time is required for geological and geophysical studies. One measure of the success of an exploratory program is by a historical analysis of past exploration activities including the actual development expenditures. The result should be a DCFROR greater than the minimum hurdle rate. On the other hand, a historical analysis of the development costs and subsequent production should result in higher historical DCFRORs than the total exploration program since the exploratory costs would be left out in this analysis.